FEDERAL INCOME TAXATION OF SECURITIZATION TRANSACTIONStaxsec.homestead.com/files/2008_Supplement.pdf · FEDERAL INCOME TAXATION OF SECURITIZATION TRANSACTIONS Third Edition, Frank

FEDERAL INCOME

TAXATION OF SECURITIZATION TRANSACTIONS

Third Edition, Frank J. Fabozzi Associates, 2001

2008 Supplement (November 13, 2008)

James M. Peaslee & David Z. Nirenberg

i

About the Supplement

This 2008 Supplement is a cumulative supplement which replaces all prior supplements. It incorporates both changes in the law and new questions or topics that were not covered in the book. To assist in use of this Supplement, we have attached separate highlights of additions made in this 2008 Supplement and in the prior seven supplements. This feature allows readers of the book to see at a glance whether there have been recent changes in areas of interest to them. The Supplement also includes a cumulative table of contents showing where in the book changes have been made.

Copyright and Use

© 2008 James M. Peaslee and David Z. Nirenberg

This Supplement is subject to the statements on the copyright page of the book. Permission is granted to any reader of the book or library to use this Supplement in conjunction with the book to update the information therein.

Book Web Site

For more information about the book, see www.securitizationtax.com.

Securitization Reforms–FASIT Repeal and Other Tax-Related Legislative Changes

A number of significant reform proposals relating to securitizations have been made and either enacted or included in proposed legislation.

In December 2002, the New York State Bar Association, Tax Section, issued a report on securitization reform measures (NYSBA Reforms Report). The report’s recommendations (which could be implemented through rulings or regulations) would make significant changes in a number of tax law areas addressed by the book. The summary of recommendations set out in the report is reproduced in an Attachment to this Supplement. Some of the more important proposals are also described in the text of this Supplement. The report includes an in-depth discussion of the topics it covers and is a useful resource. For the full text, see NYSBA, “Securitization Reform Measures,” 98 Tax Notes 795 (Special Supplement, February 10, 2003), or the NYSBA Web site at http://www.nysba.org/taxreports/ (report number 1024).

The report takes as its starting point a letter written by the authors to the Treasury in 2001. The basic idea of the letter and report is that the FASIT legislation had failed and should be replaced with a series of narrow tax law changes.

On February 13, 2003, the Joint Committee on Taxation released a report analyzing certain structured transactions entered into by Enron Corporation. Two of the transactions involved FASITs. The Joint Committee recommended repeal of the FASIT rules on the ground that they were not being widely used in the manner envisioned by Congress, thus failing to further their intended purposes. Moreover, the abuse potential inherent in the FASIT vehicle far outweighed any beneficial purpose it might serve.

ii

Following the Joint Committee recommendation, FASIT repeal legislation was enacted on October 22, 2004, as part of the American Jobs Creation Act of 2004 (“AJCA 2004”), generally effective January 1, 2005. Ashes to ashes, dust to dust. For a more detailed description, see Chapter 16, Part A (in this Supplement).

AJCA 2004 also makes changes, described in Chapter 6, Part B.2 (in this Supplement), expanding the types of assets that can be held by REMICs. The changes facilitate securitizations of reverse mortgages and other mortgages providing for ongoing advances of principal. AJCA 2004 also limits carryover basis transfers of high-basis, low-value assets, including REMIC residual interests (see Chapter 9, Part E.4.i. (in this Supplement)), and makes section 754 elections mandatory for partnerships if there is substantial built-in loss (under section 743) or substantial basis reduction (under section 734), with an exception for securitization partnerships and, in the case of section 743, electing investment partnerships (see Chapter 5, Part C.2, in this Supplement).

Bills were introduced in 2004 and 2005 that would create a safe-harbor rule permitting qualified mortgages held by a REMIC to be modified without changing their status as qualified mortgages. These bills have not been enacted. In November 2007, the IRS issued proposed regulations that would expand the safe-harbor list of permitted modifications in the REMIC regulations (see Chapter 6, Part D.2, in this Supplement).

REMIC thought for the day: “A REMIC residual interest is a child of the code that would not be found ‘in nature’.” Jasper L. Cummings, Jr. and Robert P. Hanson, “New Limitations on Corporate Built-in Losses,” 107 Tax Notes 1553, 1554 (June 20, 2005).

Tax Strategy Patents

Just when you thought you had enough to worry about in considering the tax consequences of transactions, a potential risk arising from the intellectual property field is that use of a tax strategy will infringe a patent. This concern may soon be put to rest by legislation restricting tax strategy patents, but that has not yet happened.

For a good article discussing tax-related patents, see Charles F. Wieland III and Richard S. Marshall, “Tax Strategy Patents─Policy and Practical Considerations,” 47 BNA Tax Management Memorandum 499 (December 11, 2006).

The United States Patent and Trademark Office web site has a list of tax-related patents and patent applications at www.uspto.gov/patft/class705_sub36t.html. As of September 23, 2008, this list included a few items referring specifically to securitizations, including a “method for securitizing retail lease assets” (20050289036), a “method and system for securitizing contracts valued on an index” (20050119962), and “methods for issuing, distributing, managing and redeeming investment instruments providing securitized annuity options” (20030083972). See also 20080114705 (May 15, 2008) describing a method for converting a taxable mortgage pool held by a REIT into a REMIC to allow sale to non-REIT investors (a “springing” REMIC). Since patent applications generally are not published until eighteen months after filing, and patents with claims affecting tax strategies and securitizations may fall within other patent subcategories as well, this list is far from exhaustive. Indeed, there are quite a number of other patents and applications relating generally to financial products and investment strategies.

iii

Tax patents are generally considered a type of business method patent. A Federal Circuit decision in 1998, State Street Bank & Trust Co. v. Signature Fin. Group, Inc., 149 F.3d 1368 (Fed Cir. 1998), opened the door to this type of patent by holding that there was no general proscription against patenting business methods. Recent Supreme Court decisions, however, have expressed some concern with the subsequent proliferation of business method patents. It will take time for the law in this area to get sorted out. A recent decision by the U.S. Court of Appeals for the Federal Circuit denying a patent for a commodity hedging strategy may significantly limit the scope of permissible tax patents. See In re Bernard L. Bilski, No. 2007-1130, October 30, 2008, reprinted in 2008 Tax Notes Today 212-13 (October 31, 2008).

Not surprisingly, the tax bar has objected vehemently to the whole idea of patenting tax strategies. See American Bar Association, Section of Taxation, “Comments Concerning a New Category of Reportable Transaction Covering Patented Tax Strategies,” 2007 Tax Notes Today 36-12 (February 21, 2007), and New York State Bar Association, Tax Section, “Patentability of Tax Advice and Tax Strategies,” 2006 Tax Notes Today 160-18 (August 17, 2006). See also Andrew A. Schwartz, “The Patent Office Meets the Poison Pill: Why Legal Methods Cannot Be Patented,” 20 Harv. J. Law & Technology 333, 366-371 (2007) (arguing that legal methods, unlike business methods, are not inventions and the policy considerations or economic incentives behind patent law are not necessary to protect or encourage the creation of useful tax strategies).

On the legislative front, the “Patent Reform Act of 2007” (H.R. 1908) was passed by the House on September 7, 2007. The bill is a broad patent reform measure that includes a prohibition on tax strategy patents. The bill would define a tax strategy patent as “a plan, strategy, technique or scheme that is designed to reduce, minimize, or defer, or has, when implemented, the effect of reducing, minimizing or deferring, a taxpayer’s tax liability.” See H.R. 1908, “Changes in Existing Law Made by the Bill, as Reported.” The Senate version of the patent reform bill (S. 1145) does not as yet include a limitation on tax strategies, and the issue will need to be resolved by the two chambers. However, the “Stop Tax Haven Abuse Act” (S. 681) introduced in the Senate on February 17, 2007 would bar any patent for a strategy “designed to minimize, avoid, defer, or otherwise affect the liability for Federal, State, local, or foreign tax.” Another bill limiting the patenting of tax planning inventions (S. 2369) was introduced in November 2007.

The Treasury has expressed its dislike of tax patents by proposing on September 26, 2007 regulations that would expand the definition of reportable transaction to include the payment of fees (or earning of fees) for the use of certain tax strategy patents. The new rules would apply to transactions entered into on or after September 26, 2007. See REG-129916-07; 72 F.R. 54615-54618. Reportable transactions are discussed in Chapter 14, Part J (in this Supplement). As a further interim measure until Congress acts, the Treasury is working with the Patent and Trademark Office to develop regulations that would disallow the patenting of tax strategies that do not include a technological component (to comply with In re Comiskey, 499 F.3d 1365 (Fed. Cir. 2007)). See 2008 Tax Notes Today 108-4 (June 4, 2008).

iv

Highlights of 2008 Supplement

New Topics/Securities

• Treatment of REMICs that acquire delinquent loans. See Chapter 6, Part D.6.b.

Changes/Clarifications of the Law

• Patent application for REIT-owned taxable mortgage pool that springs into a REMIC. See the preface, above, to this Supplement.

• Announcement by Financial Accounting Standards Board of proposed revisions to Statement 140 and Interpretation 46(R), which among other things would eliminate the concept of a qualifying special purpose entity. See Chapter 2, Part D.3.

• Announcement by New York State that starting in 2009 it will regulate as insurance credit default swaps entered into by protection buyers who own the underlying securities (potentially influencing their tax treatment). See Chapter 2, Part H.

• Revenue Procedure 2008-58, holding that a holder of auction rate securities that is effectively granted a put right to sell the securities to settle claims is not thereby divested of tax ownership pending exercise of the put right. See Chapter 3, Part D.1.c.

• Coordinated Issue Paper on Variable Prepaid Forward Contracts Incorporating Share Lending Arrangements, which concludes that such transactions involve current sales. See Chapter 3, Part D.1.i.

• Revenue Ruling 2008-1, concluding that a prepaid forward contract on foreign currency is properly treated as debt, and Notice 2008-2, asking for comments on the proper treatment of prepaid forward contracts that are not treated as debt. See Chapter 3, Part E.1.

• Revenue Ruling 2008-8, Notice 2008-19, and P.L.R. 200803004 (dated October 15, 2007) relating to the tax treatment of companies that are divided into protected cells (also known as segregated portfolios or series). See Chapter 4, Part C.2.

• Notice 2008-34, stating that a distressed asset trust transaction in which a trust was used as a means of conveying high basis assets from a tax-indifferent party to a U.S. taxpayer would be challenged on various grounds, including that the trust was not a trust but rather a business entity. See Chapter 4, Part D.2.c.

• P.L.R. 200844002, holding that a foreign pension plan organized as a trust was classified as a trust. See Chapter 4, Part D.2.c.

v

• Announcement 2008-41, withdrawing proposed regulations that would have limited the scope of section 1221(a)(4) and treated newly originated loans as capital assets. See Chapter 4, Part F.3.b.(i).

• Treasury Regulation § 1.1446-6, which are final regulations addressing a foreign partner’s certification of deductions and losses to a partnership for purposes of determining withholding of tax with respect to the partner’s effectively connected income. See Chapter 5, Part C.7.a.

• Revenue Procedures 2008-47 and 2008-28, allowing REMIC or grantor trust servicers to modify a mortgage held by a REMIC or grantor trust if the borrower is part of a group that is considered likely to default based on general information relating to the loan, property and borrower without direct knowledge concerning the borrower. See Chapter 6, Part D.2.d.

• Statement by an IRS official at an ABA meeting raising questions about whether a REMIC that is a “workout factory” formed to modify already defaulted loans might be too active to be a REMIC. See Chapter 6, Part D.6.

• Notice 2008-15, relating to the treatment of prepaid mortgage insurance premiums. See Chapter 8, Part G.3.a.

• T.A.M. 200814026, rejecting a taxpayer’s arguments for accelerating bad debt deductions for payments on notes issued by a trust owned by the taxpayer. Chapter 8, Part H.2.

• Section 856 amendments, clarifying that foreign currency gains and losses relating to permitted foreign currency denominated investments and related foreign currency borrowings and hedges do not cause an entity to fail to be a REIT. See Chapter 11, Part B.1.

• Chief Counsel Advice 200817035, concluding that a taxpayer that was a dealer in securities within the meaning of section 475 and had acquired certain securities for investment had not shown that the securities were held primarily for sale to customers in the ordinary course of business based on the adoption of a business plan requiring greater levels of sales to increase capital. See Chapter 11, Part F.5.

• Treasury Regulation § 1.863-1(e)(2), which is a final regulation superseding a temporary regulation adopted in 2006 which treats excess inclusion income on a REMIC residual interest as income from United States sources, even if the REMIC holds exclusively foreign mortgages. See Chapter 12, Part C.1.

• Treasury Regulation § 1.860G-3(b), which is a final regulation superseding a temporary regulation adopted in 2006 which requires a partnership holding a REMIC residual interest and having a foreign partner to pay currently withholding tax on income from the residual interest allocable to the foreign partner. See Chapter 12, Part C.1.

vi

• Swallows Holding Ltd., a circuit court case reversing a Tax Court decision from 2006 that had invalidated regulations requiring that a return be timely filed by a foreign corporation in order to claim deductions where the taxpayer had filed before being contacted by the Service. See Chapter 13, Part D.

• T.A.M.s 200811018 and 200811019, which analyze whether investment or trading securities held by a bank are treated as effectively connected with the banking business conducted through a U.S. office under special rules applicable to a banking, financing or similar business. See Chapter 13, Part D.4.

• Notice 2008-77, which states that the IRS will not assert penalties on trustees or middlemen for failing to comply with the widely held fixed investment trust (WHFIT) reporting rules for 2008 and eliminates for the time being a requirement to report mortgage modification where resulting shortfalls are compensated through a guarantee arrangement. See Chapter 14, Part C.2.

• Treasury Form 90-22.1, “Report of Foreign Bank and Financial Accounts” (FBAR), revised instructions, require certain persons establishing a foreign trust having a foreign bank account or other financial account to file the form with the Treasury or face potentially severe penalties. See Chapter 14, Part H.4.

• Designation as a Tier III audit issue of the issue of REMIC sponsors’ understatement of reportable gain on the retention and the sale of regular interests. See Chapter 15, Part E.

vii



• Potential effect of tax strategy patents on securitizations. See the preface, above, to this Supplement.

• Article by one of the authors on the tax classification of segregated portfolio companies (similar to companies or trusts divided into series). See Chapter 4, Part C.

• Treatment of subordinated parity lien debt in determining if senior debt is principally secured by real property, and treatment of Maryland Indemnity Deed of Trust (or IDOT) structures. See Chapter 6, Part B.2.a.(ii).

• Treatment of foreign withholding taxes imposed on interest received by a REMIC. See Chapter 9, Part D.

• Offshore issuers as REIT subsidiaries. See Chapter 11, Part B.


• IRS AM 2007-004, a Chief Counsel Attorney Memorandum, which further explains the IRS position that a prepaid variable forward contract combined with a stock loan amounts to a current sale. See Chapter 3, Part D.1.i.

• Littriello, a District Court case holding that the check-the-box regulations were valid, has been upheld on appeal and joined by a second case, Sean P. McNamee, to the same effect. See Chapter 4, Part A.

• Final regulations treating entities that are disregarded for income tax purposes as separate entities for purposes of employment tax and certain excise taxes. See Chapter 4, Part B.4.

• IRS AM 2007-005, a Chief Counsel Attorney Memorandum, which characterizes as a partnership a state law trust formed to hold interests in a limited liability company that has the power to vary its investments and that itself was treated as a partnership for tax purposes. See Chapter 4, Part D.4.f, and Chapter 14, Part C.

• P.L.R. 200722007, which concludes that subpart F income from a CFC earned by a partnership is passive income for purposes of the publicly traded partnership rules, on the ground that such income is “other income” derived from the partnership’s business of investing in the stock within the meaning of section 851(b). See Chapter 4, Part F.3.a.

viii

• Revenue Ruling 2007-13, holding that the grantor of an insurance trust is the owner of the underlying insurance policy for purpose of applying section 101(a) to transfers of the policy by the trust. See Chapter 5, Part B.2.

• P.L.R. 200648023, a ruling holding that a minor change in a defeasance clause relating to the timing of payments on Treasury collateral that was not a section 1001 exchange did not prevent application of the REMIC rule allowing defeasances of mortgages. See Chapter 6, Part B.2.a.(ii).

• Revenue Ruling 2006-58, which holds that a charitable remainder unit trust or annuity trust is considered a disqualified organization in applying the excess inclusion rules. See Chapter 6, Part B.3, and Chapter 9, Part E.4.c.

• Proposed Treasury Regulation §§ 1.860G-2(a)(8) and (b)(3), expanding the safe harbor rules allowing modifications of mortgage loans held by REMICs, issued in response to Notice 2007-17, which requests assistance in determining whether to amend REMIC regulations to permit certain modifications of securitized commercial mortgage loans. See Chapter 6, Part D.2.

• Revenue Ruling 2007-1 which addresses the treatment by credit card issuers of credit card nonsufficient funds fees. See Chapter 8, Part G.2.

• Revenue Ruling 2007-32, which discusses the accrual of interest on delinquent loans by banks. See Chapter 8, Part H.2.

• IRS AM 2007-014, an IRS Chief Counsel Attorney Memorandum, which concludes that a taxpayer may integrate a convertible note with a call option it purchases without being required to also integrate such note with a warrant it issues. See Chapter 8, Part H.4.c.

• Notice 2006-97, which provides guidance on the taxation and reporting of excess inclusion income by REITs and RICs. See Chapter 9, Part E.4.c.

• Notice 2007-42 and Revenue Ruling 2007-33, which clarify how the REIT asset and income tests are affected by foreign currency transactions. See Chapter 11, Part B.1.

• Treasury Regulation § 1.475(a)-4, a final regulation adopting a safe harbor method for determining the fair market value of securities under section 475 based on values used for financial statement purposes. See Chapter 11, Part F.1.

• Treasury Regulation § 1.871-14(g), a final regulation which, in the case of interest received from U.S. sources by a partnership or trust with foreign partners or owners, would apply the 10-percent shareholder carve out from the withholding tax exemption for portfolio interest at the partner or owner level (and not to the partnership or trust). See Chapter 12, Part C.2.

ix

• New York City Bar Association Report on Offshore Lending Activity, which includes proposed safe-harbor rules that if met would allow an offshore issuer to acquire interests in loans at or about the time of origination without being considered to be engaged in a lending business. See Chapter 13, Part D.3.b.

• Treasury Regulation §§ 1.6011-4 and 301.6111, which are final regulations amending the definition of reportable transaction and updating the material advisor rules to reflect AJCA 2004 amendments. See Chapter 14, Part J.

• Statement by IRS officials on October 11, 2007 to the effect that the IRS is pursuing many billions of dollars of audit adjustments for REMIC sponsors arising from the undervaluation of retained REMIC residual interests. See Chapter 15, Part E.

x



• Treatment of agency arrangements in which the agent is owned by the principal–another body of law relating to tax ownership. See Chapter 3, Part D.1.m.

• Aggregation of REMICs in calculating income from residual interests. See Chapter 9, Part D.


• Revenue Procedure 2005-62, which expands a 2002 revenue procedure providing safe-harbor rules for treating as a borrowing for tax purposes debt issued in a stranded cost securitization. See Chapter 3, Part D.1.k.

• Principal Life Insurance Company, a case supporting the view that only nominal equity is required by a special purpose, bankruptcy-remote entity that holds high quality debt instruments producing cash flows matching required payments on issued debt. See Chapter 3, Part E.2.b.(ii).

• Treasury Regulation § 1.882-5T, which changes the safe-harbor debt-equity rule for determining the interest expense of U.S. branches of foreign banks by increasing the assumed amount of debt from 93 percent of assets (equity of 7 percent) to 95 percent (equity of 5 percent). See Chapter 3, Part E.2.c.(iii).

• Treasury Regulation §§ 301.7701-2(b)(9) and 301.7701-5, final regulations dealing with multiple-chartered entities, which follow 2004 temporary regulations but provide greater grandfather protection. See Chapter 4, Parts B.2 and B.3, and Chapter 13, Part B.

• Proposed Regulation § 301.7701-2(c)(2)(iv) and (v), part of a package of proposed regulations that would treat disregarded entities as separate entities for purposes of certain employment taxes and excise taxes. See Chapter 4, Part B.4.

• P.L.R. 200613027, a ruling applying the rescission doctrine to allow a taxpayer to ignore the conversion of an LLC to a corporation where the conversion was later reversed during the same taxable year. See Chapter 4, Part B.4.

• P.L.R. 200624005, an important ruling, which holds that floating rate and inverse floating rate strips carved out of interest payments on fixed rate mortgages qualify as stripped coupons under section 1286. See Chapter 4, Part D.6, and Chapter 8, Part D.1.

• Proposed Regulation § 1.1221-1(e), which would overturn Burbank Liquidating and prevent a loan of money from qualifying as an ordinary asset on the ground

xi

that it represents a receivable acquired for the service of making funds available. See Chapter 4, Part F.3.b.

• Technical corrections to AJCA 2004 changes to REMIC rules. See Chapter 6, Part B.2.a.(v).

• Revenue Ruling 2005-47 and Revenue Procedure 2005-47, which address the treatment by credit card issuers of ATM surcharges. See Chapter 8, Part G.2.

• Revenue Ruling 2005-68, which illustrates how the excess inclusion rules and NOL rules interact. See Chapter 9, Part E.4.a.

• Treasury Regulation § 1.863-1T(e)(2), which treats excess inclusion income on a REMIC residual interest as income from United States sources, even if the REMIC holds exclusively foreign mortgages. See Chapter 12, Part C.1.

• Treasury Regulation § 1.860G-3T(b), which requires a partnership holding a REMIC residual interest and having a foreign partner to pay currently withholding tax on income from the residual interest allocable to the foreign partner. See Chapter 12, Part C.1.

• Proposed Regulation § 1.871-14(g), which, in the case of interest received from U.S. sources by a partnership or trust with foreign partners or owners, would apply the 10-percent shareholder carve out from the withholding tax exemption for portfolio interest at the owner level (and not to the partnership or trust). See Chapter 12, Part C.2.

• Swallows Holding Ltd., a case holding that regulations requiring that a return be timely filed by a foreign corporation in order to claim deductions were invalid where the taxpayer had filed before being contacted by the Service. See Chapter 13, Part D.

• Addition to the 2006-2007 IRS Business Plan of guidance on lending activities under section 864 (whether those activities give rise to a trade or business). See Chapter 13, Part D.3.b.

• Treasury Regulation § 1.951-1(e)(5), a final regulation which addresses the effect of restrictions and other limitations on distributions on allocations of subpart F income among multiple classes of equity. See Chapter 13, Part G.5.

• Treasury Regulation § 1.671-5, which beginning January 1, 2007 will apply more extensive information reporting rules to widely held fixed investment trusts (WHFITs). The regulations also provide special rules for information reporting by widely held mortgage trusts (WHMTs). See Chapter 14, Part C.

• Notice 2006-6, which eliminates the book-tax category of reportable transactions. See Chapter 14, Part J.

ix



• Description of PAYGO swaps, a new type of credit derivative used to create synthetic exposure to mortgage- and other asset-backed securities. See Chapter 2, Part H. and Chapter 8, Part H.3.a.

• Treatment of a REMIC regular interest held by a controlled foreign corporation as an investment in United States property within the meaning of section 956 giving rise to a deemed distribution under the subpart F rules. See Chapter 6, Part D.8.

• Treatment of periodic interest payments on a subordinated class of asset-backed securities as amounts that are “payable unconditionally” and therefore qualified stated interest payments (not includible in original issue discount). See Chapter 8, Part C.1.

• Treatment of a variable rate debt instrument that is stripped. See Chapter 8, Part D.2.


• Repeal of FASIT rules by AJCA 2004. See Chapter 2, Part G, and Chapter 16.

• Notice 2005-53, which indicates that the IRS is considering changing the safe-harbor debt-equity rule for determining the interest expense of U.S. branches of foreign banks by increasing the assumed amount of debt from 93 percent of assets (equity of 7 percent) to between 94 and 96 percent (equity of 6 to 4 percent). See Chapter 3, Part E.2.c.(iii).

• T.A.M. 200419001, which finds no violation of the consistency requirement under section 385(c)(1) where investment was designated as long term debt for purposes of foreign tax and capital flow restrictions, but as equity for U.S. federal income tax purposes. See Chapter 3, Part E.4.

• Littriello, a case which held that the check-the-box regulations were valid. See Chapter 4, Part A.

• Treasury Regulation § 301.7701-2T(b)(9), which treats a multiple-chartered entity as a per se corporation if the entity would be treated as a per se corporation as a result of its status in any one of the jurisdictions in which it is created or organized, and Treasury Regulation § 301.7701-5T, which treats an entity created or organized both in the United States and in a foreign jurisdiction as a domestic entity. See Chapter 4, Parts B.2 and B.3, and Chapter 13, Part B.

• Notice 2004-68, which adds certain European public limited liability companies to the list of per se corporations. See Chapter 4, Part B.2.

x

• Treasury Regulation § 301.7701-3(c)(1)(v)(C), which, like similar rules for REITs and tax-exempt entities, provides that an eligible entity that makes a valid S corporation election is treated as also having made an election to be classified as a corporation. See Chapter 4, Part B.2.

• Treasury Regulation § 301.7701-2(c)(2)(iii), a final regulation which clarifies that the tax classification of an entity generally does not affect the legal rights of the IRS as a creditor of the entity. See Chapter 4, Part B.4.

• Revenue Ruling 2004-88, which holds that a disregarded entity was treated as separate from its owner for certain partnership reporting and procedural purposes. See Chapter 4, Part B.4.

• Revenue Ruling 2004-77, a wholly-unsurprising ruling which holds that if an eligible entity has two members under local law, but one of the members is, for federal tax purposes, disregarded as an entity separate from the other member of the eligible entity, then the eligible entity cannot be classified as a partnership and is either disregarded as an entity separate from its owner or an association taxable as a corporation. See Chapter 4, Part B.5.

• P.L.R. 200450003, which holds that an arrangement for pooling assets in an account created by a bank for purposes of custody and investment management does not create joint ownership with respect to the bank’s withholding and information reporting obligations. See Chapter 4, Part C.

• P.L.R. 200517020, which holds that a trust formed to hold portfolio company investments previously held by a liquidated venture capital fund and to make follow-on investments in equity or debt of the same portfolio companies was a business trust. See Chapter 4, Part D.2.b.

• Revenue Ruling 2004-86, which analyzes the tax treatment of a multi-owner Delaware statutory trust formed to hold real estate and provides some insights into issues relating to the tax classification of investment trusts. See Chapter 4, Part D.2.c.

• Section 1286(f), added by AJCA 2004, which authorizes regulations that apply rules similar to the stripped bond and preferred stock rules to stripped interests in money market funds (and certain other accounts). The 2004-2005 IRS Business Plan includes guidance under section 1286(f) as a project the IRS expects to complete in the plan year ending June 30, 2005. See Chapter 4, Part D.6.d.

• F.S.A. 200512020, which holds that a trust arrangement used to strip dividends from preferred stock is a partnership because it fails to qualify for the “incidental to” exception for multiple-class trusts in the Sears regulations. See Chapter 4, Part D.6.d.

xi

• Section 704(c), as amended by AJCA 2004, which requires that a built-in loss be taken into account only by the contributing partner and not by other partners. See Chapter 5, Part C.2.

• Sections 743 and 734, as amended by AJCA 2004, which require an inside basis adjustment, under section 743 on the sale or exchange of a partnership interest if the partnership has a substantial built-in loss immediately after the transfer, and under section 734 on the distribution of property to a partner if there is a substantial basis reduction, in each case with an exception for securitization partnerships. See Chapter 5, Part C.2.

• Final and temporary regulations under section 1446, which concern withholding by partnerships of tax on partnership income allocable to foreign partners that is effectively connected with a U.S. trade or business. See Chapter 5, Part C.7.a.

• Treasury Regulation § 1.6031(a)-1(a)(3)(ii), which authorizes the IRS to provide for an exception to partnership reporting under section 6031 if all or substantially all of a partnership’s income is derived from the holding or disposition of tax-exempt obligations or shares in a regulated investment company that pays exempt-interest dividends. See Chapter 5, Part C.8.

• Notice 2004-53, which requests comments on regulations under section 761(a)(1) allowing an election out of subchapter K by certain investment partnerships. See Chapter 5, Part C.8.

• Revenue Procedure 2005-20, which updates standards for applying the diversification test for RICs in section 851 to investments in eligible tax-exempt partnerships to take account of the issuance of Revenue Procedure 2003-84. See Chapter 5, Part C.8.

• P.L.R. 200518033, which holds that a pre-construction appraisal of land and a post-construction replacement cost study obtained according to HUD standards can be used as a basis for establishing the value of real property securing a loan for purposes of applying one of the REMIC qualified mortgage tests. See Chapter 6, Part B.2.a.(ii).

• Amendment to Treasury Regulation § 1.860F-4(a), which provides that the identity of a holder of a REMIC residual interest is not a partnership item addressed in a REMIC-level audit. See Chapter 6, Part E.2.a.

• Proposed Regulation § 1.1275-2(m), which provides special rules for addressing the lag feature in REMIC regular interests. The 2004-2005 IRS Business Plan includes regulations regarding accruals for certain REMIC regular interests as a project the IRS expects to complete in the plan year ending June 30, 2005. See Chapter 8, Parts A and H.5.

xii

• Treasury Regulation § 1.988-6, which extends the principles of the current contingent payment debt instrument rules to contingent payment debt instruments for which one or more payments are denominated in, or determined by reference to, a nonfunctional currency. Chapter 8, Part C.3.

• Announcement 2004-75, which requests comments on proposed regulations the IRS is considering adopting regarding the proper timing of income and deductions relating to interest-only REMIC regular interests. The 2004-2005 IRS Business Plan includes guidance on interest-only REMIC regular interests as a project the IRS expects to complete in the plan year ending June 30, 2005. See Chapter 8, Part H.1.f.

• Notice 2004-52, which announces that the IRS is analyzing all of the tax issues raised by credit default swaps and requests comments regarding certain economic and business terms typical in the credit default swap market, as well as the accounting and regulatory treatment of these contracts. See Chapter 8, Part H.3.a.

• IR-2004-97, in which the IRS announces the settlement of disputes with Diversified Financial Corporation and AVM L.P. relating to transfers of REMIC residual interests to partnerships with foreign partners. See Chapter 9, Part E.4.e.(ii).

• Amendments to sections 362 and 334(b) by AJCA 2004, which generally require a step down in basis of built-in loss property (including REMIC residual interests) to fair market value following certain carryover basis transfers of such property to corporations. See Chapter 9, Part E.4.i.

• T.A.M. 200439041, which holds unsurprisingly that a bank holding servicing rights on mortgages owned by others may not include those mortgages in its loans outstanding for purposes of determining bad debt reserves under section 585. See Chapter 11, Part B.

• Proposed Regulation § 1.475(a)-4, which provides a safe harbor rule allowing taxpayers to elect to use the values of positions reported on certain financial statements as the fair market values of those positions for purposes of section 475. See Chapter 11, Part F.1.

• P.L.R. 200429011, which declines to provide an extension of time for a taxpayer to make an election under section 475(f). See Chapter 11, Part F.1.

• Sections 871(k) and 881(e), enacted by AJCA 2004, which permit RICs to distribute “interest-related dividends” and “short-term capital gain dividends” free of withholding tax. The 2004-2005 IRS Business Plan includes guidance under AJCA 2004 regarding the treatment of certain RIC dividends for withholding tax purposes and guidance under section 871(k) regarding RIC dividend designations as projects the IRS expects to complete in the plan year ending June 30, 2005. See Chapter 12, Part C.1.

xiii

• Section 7874, added by AJCA 2004, which provides corporate inversion rules that classify as domestic corporations certain foreign corporations that are successors to domestic partnerships or corporations. See Chapter 13, Part B.

• The elimination in AJCA 2004 of special tax regimes for foreign personal holding companies and foreign investment companies and an amendment that excepts foreign corporations from the definition of personal holding company. See Chapter 13, Parts G.2, G.3 and G.6.

• Proposed Regulation § 1.951-1(e)(5), which addresses the effect of restrictions and other limitations on distributions on allocations of subpart F income among multiple classes of equity. See Chapter 13, Part G.5.

• Treasury Regulation §§ 1.6050P-1(e)(5) and 1.6050P-2, which address when an entity will be considered to be engaged in a significant money lending business for purposes of the reporting rules for discharge of indebtedness income. See Chapter 14, Part I.

• Sections 6707A and 6662A, added by AJCA 2004, which introduce penalties for failing to disclose reportable transactions and for tax deficiencies attributable to such transactions. See Chapter 14, Part J.

• Amendments to Circular 230 imposing minimum standards for covered opinions (generally written tax advice on tax-motivated transactions (broadly defined)). See Chapter 14, Part J.

xiv



• Treatment of variable life insurance and annuity contracts (contractual claims against insurance companies that provide a return based on the performance of underlying assets) as ownership interests in the related assets—another body of law relating to tax ownership. See Chapter 3, Part D.1.l.

• Stripping the floor rate on a floating rate loan into floating rate and inverse floating rate components. Chapter 4, Part D.6.a.

• Possible treatment as market discount of discount created through the allocation of basis between senior and subordinated pass-through certificates. Chapter 15, Part C.1.


• Revenue Procedure 2004-28, which treats a repo on Government securities as a government security for purposes of the RIC rules, based on definitions in the Investment Company Act of 1940. See Chapter 3, Part D.1.b, and Chapter 5, Part B.2.

• Treasury Regulation § 301.7701-2(b)(6), which clarifies that a business entity wholly owned by a foreign government (or certain entities controlled by a foreign government) will be treated as a per se corporation. See Chapter 4, Part B.2.

• Revenue Ruling 2003-125, which holds that an election to reclassify a foreign corporation as a disregarded entity triggers a worthless stock deduction if the stock is in fact worthless. See Chapter 4, Part B.4.

• Revenue Ruling 2004-41 and Proposed Regulation § 301.7701-2(c)(2)(iii), which clarify that the tax classification of an entity generally does not affect the legal rights of the IRS as a creditor of the entity. See Chapter 4, Part B.4.

• P.L.R. 200323015, which confirms that a trust issuing floating rate/inverse floating rate interests in a pool of tax-exempt municipal bonds qualifies as a partnership (and not a bond stripping arrangement). See Chapter 4, Part D.6.a.

• Revenue Procedure 2003-84, which supersedes earlier revenue procedures and provides simplified partnership income reporting rules for partnerships that hold tax-exempt bonds and issue floating rate and inverse floating rate interests. See Chapter 5, Part C.8.

• P.L.R. 200321015, which holds that the release of a lien securing a mortgage loan in connection with the sale of mortgage collateral and defeasance of the loan were in accordance with the loan’s terms (and thus did not involve a modification)

xv

where the release and defeasance were not provided for in the loan documents but were permitted under applicable case law governing rights of a mortgagor. See Chapter 6, Parts B.2.a.(ii) and D.2.c.(i).

• Revenue Procedure 2003-65, which, following earlier private letter rulings, provides a safe harbor rule for treating a loan that is secured by equity in a partnership or disregarded entity that holds real property as a loan secured by real property under the REIT rules; the guidance also should be relevant in applying the REMIC definition of qualified mortgage. See Chapter 6, Part B.2.a.(iii), and Chapter 11, Part B.

• P.L.R. 200315001, which confirms that the conversion of a corporation that has outstanding debt into a disregarded entity owned by a different corporation does not constitute a modification of the debt under section 1001, because there is no alteration of legal rights. See Chapter 6, Part D.2.c.(i).

• P.L.R. 200347016, which treats debt secured by credit card receivables as not subject to the PAC method where, on the facts of the ruling, the likelihood of prepayment of the debt instrument was remote in light of the expected timing and amount of payments on the receivables. See Chapter 8, Parts C.2 and H.4.b.

• Revenue Ruling 2004-52, which treats credit card annual fees as income other than interest that is includible in income as the fees become due and payable under the terms of the credit card agreement; Revenue Procedure 2004-32, which allows annual fees to be accounted for ratably over the period to which they relate; and Revenue Procedure 2004-33, which allows credit card issuers to treat income from late fees as interest income, or as OID that potentially may be spread over the remaining life of the receivables under the PAC method. See Chapter 8, Part G.2.

• The 2003-2004 IRS Business Plan, which, among other things, includes for the first time guidance on interest-only REMIC regular interests (presumably aimed at the treatment of prepayment losses). See Chapter 8, Part H.1.a.

• Proposed Regulation § 1.446-3(g)(6), which prohibits the use of the wait-and-see method of accounting for contingent nonperiodic payments on notional principal contracts (swaps) and requires instead a method based on accruing anticipated payments or, alternatively, an elective mark-to-market method. See Chapter 8, Part H.3.a.

• Treasury Regulation § 1.446-5, which requires issuance expenses relating to debt instruments issued on or after December 31, 2003 to be amortized under a constant yield method. See Chapter 9, Part B.

• Proposed legislation relating to REMIC residual interests, which would require a step down in basis to fair market value following a section 351 transfer and

xvi

possibly other carryover basis transfers between corporations and could apply retroactively. See Chapter 9, Part D.

• T.A.M. 200404034, which holds that the rule preventing the offset of REMIC excess inclusion income with losses applies at the consolidated group level even for a group with a life insurance company subgroup. See Chapter 9, Part E.4.a.

• Treasury Regulation § 1.446-6, which requires that an inducement fee received for acquiring a noneconomic REMIC residual interest be recognized over the remaining expected life of the REMIC, effective for taxable years ending after May 10, 2004. See Chapter 9, Part E.4.g.(ii).

• Revenue Procedure 2003-78, which establishes procedures for taking advantage of treaty withholding tax exemptions for insurance premiums. Chapter 13, Part I.

• Announcement 2004-4, which announces a new requirement, effective January 1, 2004, for a U.S. direct or indirect owner of a foreign disregarded entity to file information returns (on new Form 8858) relating to the foreign entity. (There is no similar requirement for domestic disregarded entities.) See Chapter 14, Part H.5.

xvii



• Synthetic variable rate tax-exempt bonds. See Chapter 2, Part J, and Chapter 5, Part C.8.

• Ability to choose the tax classification of an entity after the fact (or at least for up to 75 days). See Chapter 4, Part B.3.

• Status of construction loans as qualified mortgages held by a REMIC (revised discussion). Chapter 6, Part B.2.a.(ii).

• Character of gain or loss realized by a bank from holding or writing options on debt. See Chapter 8, Part H.3.b.

• Treatment of existing market discount on a qualifying debt instrument when that instrument is combined with a hedge and treated as a newly issued synthetic debt instrument. See Chapter 8, Part H.4.e.

• Effect of ownership of a REMIC residual interest on foreign tax credits. See Chapter 9, Part D.

• Uses of REMIC residual interests to duplicate losses. See Chapter 9, Part E.4.i.

• Application of 30 percent withholding tax to payments made to a foreign person under a credit swap. See Chapter 12, Part C.

• Tax shelter reporting rules. See Chapter 14, Part J.


• Interpretation No. 46, an interpretation of GAAP from the Financial Accounting Standards Board, which (broadly) sets out new, tougher consolidation standards for special purpose entities but without requiring consolidation of QSPEs. Chapter 2, Part D.2.

• Revenue Ruling 2003-7, which holds that a prepaid variable forward contract on publicly traded stock does not cause a current actual or constructive sale of the stock. A Tax Court petition filed in 2002 indicated that at least one IRS examining agent had taken the position that a variable prepaid forward contract effected a current sale. See Chapter 3, Part D.1.i.

• Revenue Procedure 2002-49, which provides guidelines for treating stranded costs securitizations (first discussed in Supplement No. 2) as financings, and not as sales of property or other events accelerating income. The revenue procedure

xviii

provides some guidance on when debt of a thinly-capitalized securitization vehicle will be treated as debt. See Chapter 3, Part D.1.k and Part E.2.c.(iii).

• Bush Administration’s Revenue Proposals included in the 2004 Budget (Bush 2004 Revenue Proposals), which would amend the earnings stripping rules under section 163(j) and create different safe harbor debt-to-equity ratios for different classes of assets. The proposals provide some guidance on what debt levels may be appropriate in different settings. See Chapter 3, Part E.2.c.(iii).

• Revenue Procedure 2002-59 (modifying and superseding Revenue Procedure 2002-15), which provides a simplified method for requesting IRS consent to the late filing of an initial entity classification election under the check-the-box rules. See Chapter 4, Part B.3.

• Revenue Procedure 2002-22, which specifies the conditions under which the IRS will issue a private letter ruling that an undivided fractional interest in rental real property is a co-ownership arrangement eligible for like-kind exchange treatment and not an interest in a partnership (a recognized entity for tax purposes). See Chapter 4, Part C.

• Proposed legislation (the American Competitiveness and Corporate Accountability Act, H.R. 5095, 107th Cong. (2002)), which would apply the rules for stripping bonds and preferred stock to accounts or entities, such as money market funds, substantially all of the assets of which are debt instruments or preferred stock. The Bush 2004 Revenue Proposals would attack equity strips in a different way by treating them as loans. See Chapter 4, Part D.6.d.

• Chief Counsel Notice CC-2002-016, taking the position that a right to receive a share of interest on a mortgage pool as a guarantee fee should never be treated as a stripped coupon subject to section 1286 if the guarantor has not previously owned an interest in the mortgages. See Chapter 4, Part D.7.

• Revenue Procedure 2002-68 (superseding Revenue Procedure 2002-16), which sets out the position of the IRS that an investment partnership with a preferred and residual class of ownership interests may not elect out of partnership tax rules under section 761. See Chapter 5, Part C.8.

• Treasury Regulation § 1.446-5, which would require debt issuance costs to be recovered under a constant yield method (rather than the straight line method as required by current law). Chapter 9, Part B.

• Joint Committee on Taxation Staff, Report on Investigation of Enron Corporation (JCT Enron Report), which recommends limitations on the ability to use carryover basis transfers of REMIC residual interests to duplicate losses. New limitations might be effective for transfers on or after February 13, 2003 (the date the report was released). See Chapter 9, Part E.4.i.

xix

• Final Treasury Regulation § 1.860E-1(c)(4), a safe harbor for transfers of noneconomic REMIC residual interests, which replaces and modifies Revenue Procedure 2001-12. See Chapter 9, Part E.4.e.(i) and Appendix C.

• Informal announcement of an IRS compliance initiative aimed at transfers of noneconomic REMIC residual interests to foreign taxpayers. Chapter 9, Part E.4.e.(ii).

• P.L.R.s 200226013, 200225034, and 20225033, which treat a loan secured by an equity interest in a partnership holding real estate as a loan secured by real estate for purposes of the REIT qualification tests. See Chapter 11, Part B.

• P.L.R. 200220028, which holds that fees paid to a trust for the exclusive right to borrow securities will not be UBTI. Chapter 11, Part C.

• Notice 2002-41, which provides guidance allowing a foreign partnership or trust to enter into an agreement with the IRS to become a “withholding partnership” or “withholding trust.” See Chapter 12, Part C.4.

• Treasury Regulation § 1.882-4, which was amended to provide that a foreign corporation’s deductions will not be disallowed for failure to file a return (or protective return) if the foreign corporation can establish that it acted reasonably and in good faith. See Chapter 13, Part D.

• F.S.A. 200224003, which concludes that the factoring by a foreign corporation of receivables of its domestic subsidiary is not a U.S. trade or business activity. Chapter 13, Part D.2.

• Proposed legislation (the American Competitiveness and Corporate Accountability Act, H.R. 5095, 107th Cong. (2002)), which would repeal the foreign personal holding company and foreign investment company rules. See Chapter 13, Parts G.2 and G.6.

• P.L.R.s 200251016, 20025017, and 200251018, which confirm that a charitable organization that holds stock in a controlled foreign corporation is not considered to realize UBTI because the corporation has incurred debt. Chapter 13, Part H.

• Revenue Rulings 2002-89, 2002-90, and 2002-91, and Notice 2002-70, which apply the tax definition of insurance to various captive insurance arrangements. Chapter 13, Part I.

• Treasury Regulation § 46.4374-1, which clarifies who is liable for the excise tax on insurance premiums paid to foreign insurers. Chapter 13, Part I.

• Reissued Proposed Regulation § 1.671-5, which would apply information reporting rules akin to the rules applicable to REMIC regular interests, including the requirements of Form 1099 reporting, to widely held fixed investment trusts

xx

(WHFITs). The proposed regulations also provide special rules for information reporting by widely held mortgage trusts (WHMTs). See Chapter 14, Part C.

• Treasury Regulation §§ 1.6050S-3 and -4T, which requires the reporting of interest paid on any “qualified education loan” in certain situations. See Chapter 14, Part I.

• Proposed Regulation § 1.6050P-2, which would provide guidance regarding when an organization is considered to be engaged in the business of lending money so as to be subject to section 6050P (reporting of discharges of indebtedness), and would extend reporting to a transferee entity that is used by a reporting entity to hold indebtedness. See Chapter 14, Part I.

• JCT Enron Report, which recommends repeal of the FASIT rules. The repeal might be effective February 13, 2003 (the date the report was released). Chapter 16, Part A.

xxi



• Synthetic CBOs and synthetic collateral held by CBO issuers.

• Stranded cost securitizations.

• The effect on the grantor trust status of a fixed investment trust of passing through to certificate holders, pro rata, rights to vote securities held by the trust.

• The ability of a REMIC to sell on conversion a mortgage that converts automatically (not at the election of the holder) from one interest rate to another.

• Whether the wash sale rules apply to inducement fees paid by the seller of a REMIC residual interest to a buyer.


• F.S.A. 200111011 (December 6, 2000), holding that the issuance of publicly offered corporate instruments, that were characterized by the issuer as an indebtedness and a forward contract to acquire a number of shares of a class of publicly traded stock (a smaller number if the shares appreciate than if they depreciate), effected a current sale of the underlying shares.

• F.S.A. 200130009 (April 20, 2001), misguided advice in which the IRS treated a plain vanilla issuance of pay-through bonds backed by mortgages as a sale rather than a financing.

• F.S.A. 200146025 (August 2, 2001), which holds, contrary to the views of the authors, that a custody arrangement used to strip dividends from stock in a money-market fund is a partnership because it fails to qualify for the “incidental to” exception for multiple-class trusts in the Sears regulations.

• Textron Inc., a case which held that a grantor trust holding stock of a foreign corporation would be treated as a person separate from the trust owner for purposes of applying certain tax rules. The case departs from the conventional practice of ignoring grantor trusts for virtually all substantive tax purposes.

• F.S.A. 200147033 (August 14, 2001), holding that guarantee fees should be sourced by analogy to interest (and not under the rule for services), which may be relevant in a number of settings.

• Final IRS regulation providing an (unfortunately) limited carve-out from the definition of a foreign trust for investment trusts (this issue affects virtually all investment trusts, even those organized under domestic law with a domestic trustee).

xxii

• Notice 2001-44, in which the IRS announced that it was soliciting comments on the appropriate method of accounting for income on notional principal contracts that provide for contingent payments.

• Notice 2001-59, asking for comments on whether interest expense should be directly allocated against interest income from closely related financial assets (e.g., matched book repos) for purposes of determining foreign source taxable income and the foreign tax credit limitation. In a similar vein, proposed FASIT regulations issued in 2000 would provide for a direct allocation of FASIT interest expense against FASIT interest income.

• P.L.R. 200152028, which holds, contrary to the views of the authors, that premium on a REMIC regular interest must be accrued under a zero prepayment assumption.

• Proposed amendments to Treasury Regulation § 46.4371-1, which provide that the excise tax on certain insurance and reinsurance premiums paid to non-U.S. insurance companies is payable not only by domestic insureds but also certain foreign insureds.

• P.L.R. 200201024, in which a nominal equity interest in a two-member LLC was ignored so as to cause the LLC to be treated as a disregarded entity.

xxiii



• Net interest margin security (NIMS), which is a type of pay-through bond that is supported by rights to receive interest spreads in prior mortgage securitizations.

• The effect of the TMP rules on resecuritizations of NIMS.

• A new type of REMIC regular interest, referred to as a guaranteed final maturity class (GFM Class). In this structure, the REMIC issuing the GFM Class promises that such class will be retired no later than a fixed date that is earlier than the date when all principal payments would be received on the qualified mortgages held by the REMIC assuming no prepayments.

• Proposals submitted by the authors to the Treasury for replacing FASITs with a number of relatively simple tax law changes.

• Questions raised in applying a rule that treats regular interests issued within a 10-day period as if they were issued on one day.

• The effect on a REMIC of acquiring foreclosure property subject to senior debt or other liens.

• Additional arguments for allowing a REMIC to hold a qualified mortgage that permits substitutions of real estate collateral with equivalent value.

• Clarification of rules for creating specified portion REMIC regular interests out of qualified mortgages that accrue interest.

• Continued application of a transition rule for a thrift holding a REMIC residual interest when the thrift transfers the residual interest in a carryover basis transaction.

• Penalties for failing to file REMIC returns.

• The effect on an offshore issuer of acquiring and holding real or personal property located in the United States upon the foreclosure of a loan.

• InverWorld Inc., a case discussing when the U.S. office of an agent should be attributed to a foreign principal, which may be relevant to the taxation of offshore issuers.


• Items in the 2001 IRS Business Plan that relate to securitizations.

xxiv

• Proposed regulations relating to straddles, including a proposed regulation that may require capitalization of periodic payments on a notional principal contract that is a position in a straddle.

• An amendment to the wash sales rules clarifying that they do not fail to apply to a contract or option to acquire stock or securities solely because the contract or option is, or could be, settled in cash.

• In light of the IRS conceding the issue, a revised discussion of authorities allowing a bank or thrift that is a cash method taxpayer to avoid the accrual of discount under section 1281 on short-term loans that it originates.

xxv

About the Authors David Z. Nirenberg is a tax partner with McKee, Nelson LLP.

xxvi

Preface The authors also wish to acknowledge the contributions of Tom Evans, Stephen J. Jackson,

Sharon Kim, Christopher Kubiak, Judy Kwok, W. Stewart McMichael III, and Bradford D. Whitehurst to the book and supplements.

Table of Contents for Supplement Page

xxvii

Chapter 1 Tax Issues in Securitization Transactions .................................................. 1

Chapter 2 Types of Asset-Backed Securities ................................................................ 3 A. Introduction...................................................................................................... 3

1. Catalogue of Securities .......................................................................... 3

B. Pass-Through Certificates ................................................................................ 3

2. Stripped Pass-Through Certificates ...................................................... 3

3. LEGOs (Strips and Combinations at the Holder’s Option.................... 3

C. Pay-Through Bonds.......................................................................................... 3

D. Equity Interests in Issuers of Pay-Through Bonds........................................... 4

3. GAAP Treatment ..................................................................................... 4

E. REMICs............................................................................................................ 5

G. FASITs ............................................................................................................. 6

H. Offshore Issuers ............................................................................................... 6

J. Synthetic Variable Rate Tax-Exempt Bonds..................................................... 8

Chapter 3 Sale/Financing and Debt/Equity Issues .................................................... 10 C. Tests for Distinguishing a Sale From a Financing—Overview ..................... 10

1. Tax Ownership.................................................................................... 10

3. GAAP.................................................................................................. 10

D. Distinguishing a Sale From a Financing—Detailed Discussion of Tax Standards.................................................................................................. 10

1. Sources of Authority on Tax Ownership ............................................ 10

a. Installment Obligations ........................................................... 11

b. Sale/Repurchase Agreements.................................................. 11

c. Options ..................................................................................... 12

e. Equipment Trusts and Similar Arrangements ......................... 13

f. Pass-Through Certificates........................................................ 13

g. Leased Property ...................................................................... 14

i. Short Against the Box.............................................................. 14

j. Timing of Sales........................................................................ 16

k. Stranded Cost Financings. ...................................................... 17

l. Variable Life Insurance and Annuity Contracts. ..................... 19

m. Agent Owned by Principal..................................................... 20

2. Transaction Patterns............................................................................ 22


xxviii

d. Prepayment and Market Value Guarantees............................. 22

E. Debt/Equity Issues.......................................................................................... 22

1. Overview of Tax Standards for Classifying Financial Instruments as Debt...................................................................... 22

2. Significance of Thin Capitalization and Asset/Debt Mismatches ...... 23

b. High-Quality Receivables and Parity Classes......................... 23

(ii) The NIPSCO and Principal Life cases...................... 24

(vii) Summary and intentional mismatches for nonbelievers ......................................................... 25

c. Lower-Grade Receivables and Junior/Senior Classes............. 25

(iii) If equity is needed, how much is enough................. 25

(iv) F.S.A. 200130009 .................................................... 26

4. Equity Interests Treated as Debt ......................................................... 29

Chapter 4 Classification of Issuers Other Than REMICs and FASITs .................. 31 A. Introduction.................................................................................................... 31

B. Overview of Entity Classification Regulations.............................................. 31

1. General................................................................................................ 31

2. Per se Corporations ............................................................................. 31

3. Default Rule and Mechanics of Election ............................................ 32

4. Effect of Elective Changes in Classification ...................................... 33

5. Number of Owners.............................................................................. 36

C. Existence of an Entity .................................................................................... 36

1. Overview............................................................................................. 36

2. Segregated Portfolio Companies......................................................... 36

a. Revenue Ruling 2008-8........................................................... 37

b. Notice 2008-19.......................................................................... 38

c. PLR 200803004......................................................................... 39

D. Status of Investment Trusts as Trusts or Business Entities............................ 41

2. Family Trusts, Business Trusts, and Investment Trusts ..................... 41

b. Business Trusts ....................................................................... 41

c. Investment Trusts .................................................................... 41

3. Trusts Holding Real Property Mortgages as Business Trusts............. 42

4. Permitted Activities of Investment Trusts .......................................... 42


xxix

d. Temporary Reinvestments ...................................................... 42

e. Modifications of and Distributions on Trust Investments....... 42

f. Partnership Interests and Loan Participations ......................... 43

g. Inside Reserve Funds .............................................................. 43

i. Certificateholder Approval ...................................................... 43

j. Incurrence of Debt ................................................................... 44

k. Swaps and Other Derivatives.................................................. 44

5. Multiple Ownership Classes ............................................................... 45

a. Overview................................................................................. 45

6. Further Applications of “Incidental” Exception ................................. 45

a. Synthetic Floating Rate Interests ............................................. 45

d. Equity Strips............................................................................ 49

7. Definition of Ownership Interest ........................................................ 52

E. Taxable Mortgage Pools................................................................................. 53

2. Definition of TMP............................................................................... 53

c. Relationship Test..................................................................... 53

(iii) Required relationship ............................................... 53

g. Anti-Avoidance Rule .............................................................. 53

F. Publicly Traded Partnerships.......................................................................... 54

3. Passive Income Exemption ................................................................. 54

a. Qualifying Income—General Definition ................................ 54

b. Interest from a Financial Business.......................................... 54

(i) Traditional definitions of a financial business ........... 54

Chapter 5 Taxation of Trusts (Other Than REMICs or FASITs) Issuing Pass-Through Certificates................................................................................. 57 B. Grantor Trusts ................................................................................................ 57

2. Application of Grantor Trust Rules to Investment Trusts .................. 57

3. Senior/Subordinated Pass-Through Certificates ................................. 58

C. Trusts Taxed as Partnerships.......................................................................... 59

1. General Approach of Subchapter K.................................................... 59

2. Inside and Outside Basis..................................................................... 59

6. Disposition of Interests ....................................................................... 60


xxx

7. Taxation of Pass-Through Debt Certificates as Partnership Interests ........................................................................................ 60

a. Foreign Investors..................................................................... 60

8. Election Out of Partnership Rules....................................................... 62

D. Other Differences........................................................................................... 65

Chapter 6 Qualification and Taxation of REMICs ................................................... 66 B. REMIC Qualification Tests............................................................................ 66

1. Interests Test ....................................................................................... 66

a. Definition of Interest ............................................................... 66

(vi) Rights of others in foreclosure property................... 66

2. Assets Test .......................................................................................... 67

a. Qualified Mortgages................................................................ 67

(i) Obligations (and interests in obligations) .................. 67

(ii) Principally secured.................................................... 67

(iii) Real property............................................................ 71

(v) AJCA 2004 changes relating to loan advances and the funding of loan purchases ....................... 71

3. Arrangements Test .............................................................................. 74

C. REMIC Taxes................................................................................................. 74

1. Prohibited Transactions Tax ............................................................... 74

3. Tax on Income From Foreclosure Property ........................................ 74

D. Special Topics ................................................................................................ 75

1. Credit Enhancement Contracts ........................................................... 75

a. Definition of Credit Enhancement Contract ........................... 75

2. Modifications and Assumptions of Mortgages ................................... 76

c. Material Modifications............................................................ 76

(i) Definition of “modification” ...................................... 76

d. REMIC Regulations................................................................ 77

3. Convertible Mortgages........................................................................ 81

6. Financially Distressed Mortgages....................................................... 82

b. Pre-Acquisition Defaults......................................................... 82

7. Integration ........................................................................................... 85


xxxi

c. Packaging REMIC Interests With Other Financial Instruments............................................................................. 85

8. REMIC Regular Interests as Investments in United States Property........................................................................................ 85

E. REMIC Elections and Other Procedural Matters ........................................... 87

2. Other Procedural Matters.................................................................... 87

a. General .................................................................................... 87

Chapter 7 Definition of REMIC Regular Interest ..................................................... 88 B. Fixed Terms.................................................................................................... 88

C. Permitted Interest Rates ................................................................................. 88

4. Specified Portions ............................................................................... 88

b. Interest Payments .................................................................... 88

D. Contingencies................................................................................................. 88

Chapter 8 Taxation of Holders of Asset-Backed Securities Taxable as Debt ......... 89 A. Introduction.................................................................................................... 89

C. Original Issue Discount.................................................................................. 89

1. OID Defined........................................................................................ 89

2. Debt Instruments Subject to the PAC Method.................................... 90

3. OID Accruals for Debt Instruments Generally ................................... 90

4. OID Accruals Under the PAC Method ............................................... 90

D. Stripped Bond Rules ...................................................................................... 90

1. Definition of Stripped Bond or Coupon.............................................. 90

2. Treatment of Stripped Bonds .............................................................. 91

F. Premium.......................................................................................................... 92

3. PAC Method ....................................................................................... 92

G. Special Considerations for Pass-Through Certificates and Other Pools........ 92

2. OID in Residential Mortgages and Other Consumer Loans ............... 92

3. Application of PAC Method ............................................................... 93

a. Overview................................................................................. 93

b. Existence of a “Pool” .............................................................. 94

c. Other Implementation Issues................................................... 95

4. Simplifying Conventions .................................................................... 95

H. Special Topics ................................................................................................ 95


xxxii

1. Prepayment Losses Attributable to IO Interests ................................. 95

f. Announcement 2004-75 .......................................................... 95

2. Delinquencies and Defaults ................................................................ 97

3. Securities Representing a Debt Instrument Combined with Another Financial Contract.......................................................... 98

a. NPCs ....................................................................................... 98

b. Call Options .......................................................................... 103

c. Other Consequences of Separate Treatment ......................... 103

4. Integration of Debt Instruments and Hedging Contracts .................. 104

b. Qualifying Debt Instruments................................................. 104

c. § 1.1275-6 Hedge .................................................................. 104

e. Effects of Integration............................................................. 105

5. Payment Lags for REMIC Regular Interests .................................... 105

Chapter 9 Taxation of Holders of Equity Interests in Trust Issuers of Debt and REMIC Residual Interests....................................................................... 109 B. Common Tax Characteristics ....................................................................... 109

C. Special Considerations Applicable to Trust Issuers..................................... 109

D. Special Considerations Applicable to REMICs ........................................... 109

E. Phantom Income........................................................................................... 112

4. Special Rules for REMICs—Excess Inclusions and Negative Value Residual Interests ............................................................ 112

a. Overview............................................................................... 112

c. Pass-thru Entities................................................................... 113

e. Certain Tax-Motivated Transfers Disregarded ..................... 116

(i) Transfers to U.S. persons ......................................... 116

(ii) Transfers to foreign investors ................................. 117

f. Flaws in Excess Inclusion Rules ........................................... 118

g. Negative Value Residual Interests ........................................ 119

i. Uses of REMIC Residual Interests to Duplicate Losses......... 121

Chapter 10 Taxation of Taxable Mortgage Pools and Holders of Equity Interests in Taxable Mortgage Pools.............................................................. 124 C. Taxation of Equity Holders .......................................................................... 124

D. REITs ........................................................................................................... 124

1. Taxation of REITs............................................................................. 124


xxxiii

2. REIT/TMPs as Quasi REMICs......................................................... 124

Chapter 11 Special Rules for REITs, Financial Institutions, Tax-Exempts, and Dealers ....................................................................................................... 126 B. REIT Income and Assets Tests and Thrift Assets Test................................ 126

1. General.............................................................................................. 126

2. Uses of REIT Subsidiaries ................................................................ 128

C. Tax-Exempt Organizations .......................................................................... 129

E. Debt Instruments Held by Banks and Thrift Institutions.............................. 130

F. Mark-to-Market Rules for Securities Dealers............................................... 131

1. Overview........................................................................................... 131

2. Definition of Dealer .......................................................................... 133

4. Exceptions to Mark-to-Market Requirement .................................... 133

5. Treatment of Gains and Losses......................................................... 134

Chapter 12 Taxation of Foreign Investors................................................................ 135 B. TEFRA Registration Requirements ............................................................. 135

1. Overview............................................................................................ 135

2. Asset-Backed Securities.................................................................... 135

C. Withholding Tax .......................................................................................... 135

1. Overview........................................................................................... 135

2. Portfolio Interest Exemption............................................................. 137

3. Income from Swaps, Rents, and Options.......................................... 138

a. Swaps .................................................................................... 138

d. Fees ....................................................................................... 139

4. Withholding Agents .......................................................................... 139

Chapter 13 Offshore Issuers ...................................................................................... 140 A. Introduction.................................................................................................. 140

B. Definition of Foreign Corporation ............................................................... 140

D. Taxation of Effectively Connected Income ................................................. 141

1. Trade or Business – Common Law Definition ................................. 142

2. Securities Trading Safe Harbor......................................................... 142

3. Special Topics................................................................................... 142

b. Loan Origination................................................................... 142

d. Foreclosure Property............................................................. 144


xxxiv

4. Effective-Connection Test ................................................................ 145

E. Withholding Tax........................................................................................... 146

F. Taxation of Debt and Equity Interests in Offshore Issuers—Overview....... 147

G. Taxation of Equity Interests in an Offshore Issuer Held by U.S. Persons ................................................................................................... 147

2. Anti-Deferral Regimes—Overview.................................................. 147

3. Historical Perspective ....................................................................... 148

4. Passive Foreign Investment Companies (PFICs).............................. 148

5. Controlled Foreign Corporations (CFCs) ......................................... 149

6. Foreign Personal Holding Companies (FPHCs) ............................... 149

H. Special Considerations Applicable to Tax-Exempt Organizations.............. 149

I. Offshore Issuers of Catastrophe Bonds ......................................................... 150

Chapter 14 Legending and Information Reporting................................................. 152 B. REMIC Regular Interests and Pay-Through Bonds..................................... 152

3. Ongoing Reporting............................................................................ 152

C. Pass-Through Certificates Issued by Grantor Trusts.................................... 152

1. Overview........................................................................................... 152

2. Reporting by WHFITs ...................................................................... 153

a. Terminology and Overview .................................................. 153

b. Who Reports to Whom ......................................................... 155

c. Timing and Method of Reporting—General......................... 155

d. What is Reported—General.................................................. 157

(i) Form 1099 ................................................................ 157

(ii) Statement to TIH..................................................... 157

e. What is Reported—Special Rules......................................... 159

(i) General de minimis exception .................................. 159

(ii) Qualified NMSHFIT exception .............................. 160

(iii) Special de minimis exception for WHMTs............ 161

(iv) NMWHFIT final tax year exception ...................... 161

f. Simplified Reporting. ............................................................... 161

(i) Safe harbor for certain NMWHFITs ........................ 161

(ii) Safe harbor for certain WHMTs .................................. 163

g. Directory of WHMT Trustees and NMWHFITs. ........................ 165


xxxv

3. Grantor Trusts That Are Not WHFITs.............................................. 165

E. REMIC Tax Returns..................................................................................... 166

F. Broker Reporting of Sales and Backup Withholding ................................... 167

H. Offshore Issuers ........................................................................................... 167

4. Foreign Trusts ................................................................................... 167

5. Foreign Disregarded Entities ............................................................ 168

I. Borrower and Miscellaneous Income Reporting ........................................... 169

J. Tax Shelter Reporting and Related Measures ............................................... 171

H. Offshore Issuers ........................................................................................... 178

Chapter 15 Taxation of Sponsors .............................................................................. 180 B. Sponsors That Are Loan Servicers, Securities Dealers, or Members of

Consolidated Groups.............................................................................. 180

3. Intercompany Transactions............................................................... 180

C. Pass-Through Certificates ............................................................................ 180

1. Issuer Classified as Trust .................................................................. 180

D. Asset Backed Securities Taxable as Debt .................................................... 181

E. REMICs........................................................................................................ 181

Chapter 16 FASITs ..................................................................................................... 183 A. Introduction.................................................................................................. 183

D. FASIT Qualification .................................................................................... 184

2. Assets Test ........................................................................................ 184

b. Cash and Cash Equivalents................................................... 184

G. Taxation of Owner ....................................................................................... 184

6. Transfers of Ownership Interests ...................................................... 184

c. Wash Sale Rule ..................................................................... 184

d. Transfers for Tax Avoidance Purpose .................................. 184

H. Special Topics .............................................................................................. 184

3. Use in Mortgage Transactions .......................................................... 184

6. Foreign Tax Credit Limitation—Allocation of Interest Expense ..... 184


xxxvi

Glossary ........................................................................................................................ 186

Appendix A................................................................................................................... 190

Appendix C................................................................................................................... 191

Attachment ................................................................................................................... 196

1

Chapter 1 Tax Issues in Securitization Transactions

Add the following at the end of the fourth paragraph on page 8:

Tax planning in the securitization area is generally defensive rather than offensive. Transactions are undertaken for non-tax reasons and the role of tax planning is to avoid unnecessary incremental taxes that would make transactions uneconomic. Offensive tax planning involves generating net tax benefits or possibly also relying on very technical readings of the tax law to achieve unanticipated results. A number of developments discussed in this Supplement suggest that more aggressive planning has become a factor in the securitization area and has come to the attention of the IRS and other governmental bodies. There are several developments worth noting.

First, the IRS finalized regulations amending a safe harbor rule for transfers of noneconomic REMIC residual interests to domestic persons. See Chapter 9, Part E.4.e.(i) (in this Supplement). The change was made in response to concerns that taxpayers were inappropriately avoiding tax on phantom income. One of the transactions under scrutiny was a transfer of residual interests to a U.S. partnership that was owned by foreign partners. Because partnerships are transparent for tax purposes, the overall tax effect of such a transfer is basically the same as a transfer to a foreign person, to the extent residual income is allocated to foreign partners. However, some taxpayers took the position that the transfer should be treated as a transfer to a domestic person (the partnership) rather than to its partners for purposes of applying limitations in the REMIC regulations on transfers to foreign persons. This resulted for a time in reduced prices being paid to induce transfers of REMIC residual interests. The reduced pricing in turn led the government to narrow the safe harbor for transfers to domestic persons, relying in part on a pricing formula.

The IRS has announced informally that it is looking more closely at transfers to partnerships with foreign partners and has threatened to impose penalties in appropriate cases. In 2004, the IRS issued a release (IR-2004-97, 2004 I.R.B. LEXIS 324 (July 26, 2004)) announcing the settlement of disputes with the Diversified Financial Corporation and AVM L.P. relating to transfers of REMIC residual interests to partnerships with foreign partners. See Chapter 9, Part E.4.e.(ii) (in this Supplement). In 2006, the IRS finally adopted temporary regulations requiring that income from REMIC residual interests earned by a domestic partnership that is allocable to a foreign partner be accounted for currently for withholding tax purposes. The regulations were issued as final regulations in 2008. See Chapter 12, Part C.1 (in this Supplement).

The revised safe harbor rules (referred to above) relating to transfers to domestic transferees do not apply to transfers of residual interests to foreign branches of a U.S. taxpayer, and the preamble to the new regulations indicates that the IRS believes such transfers are not effective under the regulations to transfer residual interests to the purported transferee. The reason to transfer residual interests to a foreign branch is to gain a foreign tax credit advantage. Specifically, a number of U.S. income tax treaties (including the one with the U.K.) treat income of a U.S. taxpayer as foreign source income for purposes of the U.S. foreign tax credit limitation in section 904 if the income can be taxed by the other country because it is earned through a branch in that other country. Thus, if a REMIC residual interest is held, for example, through a U.K. branch of a U.S. bank, the income from the residual interest may qualify as foreign source income under the U.S.-U.K. treaty allowing the bank to use additional credits for U.K. taxes.

Chapter 1

2

Assuming the U.K. taxes the residual interest based on its economic income and not its taxable income as measured for U.S. purposes, holding the residual interest through a U.K. branch does not result in significant additional U.K. taxes. It is interesting to note that the bank transferring REMIC residual interests to an Enron subsidiary in transactions described in the JCT Enron Report (see below) was said to be acting through its London branch.

In 2006, the IRS adopted regulations treating excess inclusion income from REMIC residual interests as domestic source income. See Chapter 12, Part C.1 (in this Supplement).

The JCT Enron Report, released on February 13, 2003, disclosed some aggressive uses of asset-backed securities and securitization structures. Specifically, Enron subsidiaries acquired high-basis, low-value REMIC residual interests in carryover basis transactions (transfers under section 351 to a corporation in exchange for stock where the transferee is controlled by the transferors after the transfer). The main purpose of the transactions seems to have been to achieve tax savings in the distant future that had little economic value but that could be used to justify current GAAP benefits. It can fairly be said that the problem lies more with the accounting rules than the tax rules. At any rate, the JCT Enron Report seems to have prompted the amendments made to sections 362 and 334(b) by AJCA 2004, which now require a step down in basis to fair market value following a section 351 transfer and other carryover basis transfers of built-in loss property, including REMIC residual interests. See Chapter 9, Part E.4.(i) (in this Supplement).

The JCT Enron Report also described the use of a FASIT in an Enron transaction to avoid limitations on earnings stripping rules under section 163(j). That section limits deductions for interest paid to a related foreign taxpayer that does not bear U.S. tax. Interest was paid by a domestic Enron entity to a foreign related party through a FASIT whose ownership interests were small and owned by an unrelated party. The report discusses another FASIT transaction in which Enron acted as an accommodation party for someone else. The JCT Enron Report recommends repeal of the FASIT rules on the ground that the opportunities for mischief outweigh the benefits. AJCA 2004 repealed the rules, generally effective January 1, 2005. See Chapter 16, Part A (in this Supplement).

Finally, like almost all areas of commercial endeavor, the securitization market is affected by the greatly expanded reporting rules for transactions with a tax avoidance potential that were first floated in 2002, came into effect in 2003, and have now been backed up by enhanced penalties adopted as part of AJCA 2004. For a discussion, see Chapter 14, Part J (in this Supplement).

The potential abuses in the securitization area appear to the authors to be a pimple on the back of an elephant. Tax planning in the area continues to be overwhelmingly defensive. The authors hope the government will keep that fact in mind in evaluating transaction patterns that raise concerns.

Chapter 2

3

Chapter 2 Types of Asset-Backed Securities A. Introduction

1. Catalogue of Securities

In footnote 2, replace “October 4, 1995” with “October 2, 1985.”

B. Pass-Through Certificates

2. Stripped Pass-Through Certificates

Insert the words “other class” immediately following “The” in the eighth line of the first full paragraph on page 21.

3. LEGOs (Strips and Combinations at the Holder’s Option)

Add the following after the first sentence in footnote 21:

The agencies also have programs for creating and disassembling stripped interests in pass-through certificates. The certificates in these programs are referred to as “Stripped Giant Certificates” (Freddie Mac), “Stripped Mortgage-Backed Securities (SMBS Certificates)” (Fannie Mae), and “Guaranteed Stripped Mortgage-Backed Securities (SMBS)” (Ginnie Mae). These programs also accommodate the LEGO exchange features. Information about these programs is available on the agencies’ web sites: www.freddiemac.com, www.fanniemae.com, and www.ginniemae.gov. For discussion of a new program feature, based on a 2006 P.L.R., that allows fixed rate interest payments to be divided into floating rate and inverse floating rate streams, see Chapter 4, Part D.6.a.

C. Pay-Through Bonds

Add the following at the end of the section:

One special type of pay-through bond is a net interest margin security (NIMS), which is a class of debt instrument supported by residual cash flows from another mortgage securitization. The residual cash flows represent the excess of interest earned on mortgages over interest on senior classes of securities. They may be evidenced by one or more subordinated IO classes (either pass-through certificates or REMIC regular interests) or REMIC residual interests. The underlying mortgages tend to be high-yield assets, such as home equity loans. NIMS are generally issued by a trust in a single class (or in multiple classes having the same payment schedule) to avoid having the trust be classified as a corporation under the TMP rules. NIMS could not be issued directly by a REMIC because, among other possible reasons, their principal amount would not be unconditionally payable because it would not be supported by mortgage principal. Although the use of net interest cash flows to support principal could raise questions as to whether NIMS should be recognized to be debt for tax purposes, the cash flows are generally

Chapter 2

4

sufficiently certain and predictable, giving effect to overcollateralization and other enhancements, to achieve at least an investment grade rating for the NIMS (including, of course, the obligation to pay principal). The equity interest in the NIMS issuer may have significant value if the mortgages perform well. The equity interest may be subject to significant transfer restrictions.32a

D. Equity Interests in Issuers of Pay-Through Bonds

3. GAAP Treatment

The following supplements Chapter 2, Part D.3:

The GAAP treatment of special purpose entities is undergoing change. The discussion below describes developments since 2001, culminating in the proposed changes announced on September 15, 2008 by the FASB. In particular, the proposed changes would put a bullet to the (quite small) brains of all qualifying special purpose entities (QSPEs) as defined in FASB 140. 37a

First, some history. The FASB issued in January 2003, and then revised in December 2003, Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements (as revised, FIN 46(R)). FIN 46(R) addresses Enron-inspired concerns over the abuse of off-balance sheet special purpose entities. FIN 46(R) addresses consolidation of variable interest entities (VIEs). A VIE is an entity that either (1) has insufficient equity at risk to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including the equity holders, or (2) has equity that lacks one or more of the following essential characteristics of a controlling financial interest: the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights, the obligation to absorb expected losses of the entity, or the right to receive the expected residual returns of the entity. Subject to some exceptions, a VIE must consolidate with the person who is the primary beneficiary of the VIE. The primary beneficiary is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are the ownership, contractual, or other pecuniary interests in an entity. FIN 46(R) has an exception for QSPEs. Specifically, it does not require consolidation of a QSPE by (1) a transferor of assets to the QSPE or its affiliates (this preserves prior practice), or (2) any other holder of equity or other variable interests in a QSPE, provided that holder does not have the unilateral ability to cause the entity to liquidate or to change it so that it no longer is a QSPE.

In short, under current practice, if an issuer is a QSPE (that cannot be unilaterally liquidated or altered to a non-QSPE), consolidation is not required. If an issuer is not a QSPE, it is necessary to determine if it is a VIE or a voting interest entity (consolidated based on traditional standards that look to voting control). If a VIE, the entity is consolidated with the primary beneficiary, if any, which is not necessarily the transferor. The same standards apply to entities that issue debt and pass-through certificates. 32a To the extent the underlying assets are REMIC residual interests, the equity in a NIMS issuer

would be subject to the same transfer restrictions as such residuals. Also, transfer may be limited to ensure that the NIMS assets are not used indirectly to support a second class of debt, which could raise an issue regarding the status of the NIMS issuer as a TMP. See Chapter 4, Part E.2.g (in this Supplement), discussing application of the TMP anti-abuse rule to NIMS issuers.

37a The definition of a QSPE in FASB 140 is discussed in Chapter 3, Part C.3 (in the book).

Chapter 2

5

The meltdown in the credit markets beginning in 2007 made it apparent that financial institutions were not consolidating entities despite having effective control and at least a moral obligation to bail them out in adverse circumstances. This led the FASB to issue in September 2008 significant proposed changes to FASB 140 and FIN 46(R).37b

The changes would eliminate the exception to the VIE rules for QSPEs. Accordingly, under the proposed changes, entities that formerly qualified as QSPEs will be subject to the consolidation standards for VIEs in FIN 46(R). In addition, those standards will be changed. Specifically, the current definition of primary beneficiary will be changed to require an enterprise to determine if the enterprise’s interests give it a controlling financial interest. In performing this qualitative analysis, an enterprise would be required to assess if it has an implicit financial responsibility to ensure that a VIE operates as designated. A quantitative test will continue to apply only if an enterprise cannot determine if it has a controlling financial interest through the qualitative analysis. Further, the primary beneficiary test must be applied on an ongoing basis.

The proposed change in the treatment of QSPEs would be effective for fiscal years ending after November 15, 2009 (so, starting in 2010 for calendar year companies) and would allow no grandfathering for existing QSPEs. As an interim measure, sponsors and investors in VIEs (including QSPEs) would be required to provide new disclosures regarding financial commitments to VIEs and financial support that has been provided even if not contractually required.

E. REMICs


A new type of REMIC regular interest, referred to as a guaranteed final maturity class (GFM Class), has recently begun to be issued. In this structure, the REMIC issuing the GFM Class promises that such class will be retired no later than a fixed date (“Final Payment Date”) that is earlier than the date when all principal payments will be received on the qualified mortgages held by the REMIC, assuming no prepayments. Either a GFM Class is the sole class of regular interest issued or all other classes of regular interests are expected to be retired prior to the Final Payment Date, even assuming that there are no prepayments on the qualified mortgages. In transactions done to date, the qualified mortgages have generally been a class of regular interests in another REMIC, although that need not be the case. The promise to retire the class amounts to a minimum prepayment guarantee (that is, a guarantee that prepayments will be no less than a specified minimum). The REMIC writes a call option (“Liquidation Call”) that entitles the holder to purchase all of the REMIC’s qualified mortgages that remain on a date (“Sale Date”) that is on or shortly prior to the Final Payment Date at a price equal to their principal amount plus accrued and unpaid interest. If the Liquidation Call is not exercised, then the REMIC sells those qualified mortgages on the Sale Date at their fair market value through an auction or bidding process. The price received in such a sale may, of course, be less than the face amount of the qualified mortgages, in which case there would be a shortfall in the cash needed by the REMIC to retire its

37b The proposed amendments are available at

http://www.fasb.org/draft/ed_transfers_financial_assets_amend_st140.pdf and at http://www.fasb.org/draft/ed_amend_fin46r.pdf. There is also a proposal for additional disclosures pending implementation of the new rules, which is at http://www.fasb.org/fasb_staff_positions/prop_fsp_fas140-e&fin46r-e.pdf.

Chapter 2

6

regular interests. To make up for the shortfall, a third party enters into a contract with the REMIC (“Shortfall Agreement”) to contribute to the REMIC on or before the Final Payment Date the amount of the shortfall. The REMIC adopts a plan of complete liquidation on or prior to the Sale Date and the REMIC liquidates within 90 days after that date. The main technical question raised by the structure is the treatment of the Shortfall Agreement under the REMIC rules. That agreement should qualify as a credit enhancement contract that is considered part of the REMIC’s qualified mortgages, but only if any mortgage loss covered by the agreement is unanticipated when the REMIC is formed. For a discussion of the technical REMIC issues, see Chapter 6, Part B (in the book and this Supplement).

G. FASITs

Add the following at the end of footnote 50:

The proposed Community Development Banking and Financial Institutions Act of 1993, which was never enacted, would have authorized the Treasury to promulgate regulations extending the principles of the REMIC rules to small business loan investment conduits. See 140 Cong. Rec. S3020-01, S3028.


FASIT repeal legislation was enacted on October 22, 2004, as part of AJCA 2004, generally effective January 1, 2005. For a more detailed description, see Chapter 16, Part A (in this Supplement).

H. Offshore Issuers


CBOs are sometimes created synthetically by having a CBO issuer use derivatives to sell credit risk to investors. Similarly, issuers of CBOs may acquire an investment portfolio with an appropriate level of risk by purchasing exposure to credit risk using derivatives.

A synthetic CBO is created by combining a high-quality noncontingent debt instrument with a default swap (sometimes referred to as a credit swap or a credit default swap) entered into between the investor (or a trust or custody arrangement acting on its behalf) and a CBO issuer.55a 55a A default swap is a contract, typically written using standardized documentation from ISDA,

wherein one party, the protection purchaser, makes periodic payments (based on a notional principal amount) in exchange for a payment from the protection seller solely upon the occurrence of a credit event (a default on a reference debt obligation or an insolvency event with respect to a reference obligor). Default swaps may be settled (1) in cash, with a payment by the protection seller equal to the excess of the principal amount of the reference obligation over its post-credit event fair market value, or, in some cases, equal to a predetermined fixed amount, or (2) physically through delivery by the protection buyer of deliverable obligations (either the reference obligations or other obligations of the reference obligor that are expected to approximate the post-default value of the reference obligations) in exchange for a cash payment by the protection seller equal to the principal amount of the reference obligation. Alternatively, a total return swap may be used. A total return swap is a contract, typically written using standardized documentation from ISDA, wherein one party, the total return purchaser, makes periodic payments (often at a floating rate) based on a notional principal amount, in exchange for payments from the total return

Chapter 2

7

The basic terms of the swap are that the CBO issuer, in exchange for a periodic fee payable by it, buys protection against credit risks in the assets the issuer holds, and the investor sells such protection and receives the fee. The debt instrument that is bundled with the swap provides a return on money advanced by the investor and also functions as collateral for the investor’s obligations under the swap. The premise behind a synthetic CBO is that the return on a debt instrument (other than Treasuries) can be broken into two separately tradable parts, interest at a risk-free rate on moneys lent plus a premium to compensate for default risk.55b An investor may achieve several potential advantages from a synthetic CBO, potentially including a higher rate of return and the ability to take on greater or less credit exposure for a given level of investment.

seller of amounts equal to all amounts paid on a reference obligation of that same notional principal amount. In addition, on termination of the swap or periodically, the total return purchaser pays an amount equal to any decrease in the value of the reference obligation and the total return seller pays an amount equal to any increase. Another type of derivative contract called a pay-as-you-go (“PAYGO”) swap has begun to be used recently to create synthetic exposure to mortgage- and other asset-backed securities. A PAYGO swap, like a default swap, shifts credit risk between a protection buyer and seller. The three main differences are that a PAYGO swap references an identified class of debt (typically an asset-backed security), has a term equal to the remaining maturity of the reference obligation, and in lieu of a one-time physical or cash settlement upon the occurrence of a credit event, requires the protection seller to pay as they occur all or a portion of any shortfall in amounts actually paid on the reference obligation compared to amounts due. A PAYGO swap may be documented as a credit swap or total return swap. In the latter case, the swap may also incorporate the economic features of a fixed-floating interest rate swap. In order to avoid characterization as a guarantee or insurance, the typical credit default swap or PAYGO swap does not require the protection purchaser to own the reference obligation.

For a discussion of the tax treatment of credit derivatives generally, see New York State Bar Association, Tax Section, “Report on Credit Default Swaps,” 2005 Tax Notes Today 176-21 (September 9, 2005) (has an excellent description of market practices and open tax issues); Bruce E. Kayle, “The Federal Income Tax Treatment of Credit Derivative Transactions,” Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2002 (Practising Law Institute), vol. 15, 913; David Z. Nirenberg and Steven L. Kopp, “U.S. Federal Income Tax Consequences of Credit Derivative Transactions,” Chapter 13, Credit Derivatives−Applications for Risk Management, Investment and Portfolio Optimisation (Risk Books 1998).

For a discussion of the characterization of default swaps as insurance, see David Z. Nirenberg and Richard J. Hoffman, “Are Credit Default Swaps Insurance?” 3 Derivatives Report No. 4 (December 2001). On September 22, 2008, New York State’s Governor David Patterson issued a press release stating that starting January 1, 2009, the State would treat a credit default swap as insurance if the protection buyer owns the underlying security. As a result, only entities licensed to conduct an insurance business will be allowed to sell protection under these contracts. However, “naked swaps” entered into for speculation (where the protection buyer does not own the underlying security) would not be regarded as insurance and will not be regulated by the State. See http://www.state.ny.us/governor/press/press_0922081.html.

A working group of the National Association of Insurance Commissioners was considering a draft of a white paper which concluded that weather derivatives should be regulated and taxed as insurance products (even if there is no requirement that the holder incurs loss). As of June 2005, discussion of the white paper has been tabled. For information about this project, see http://www.naic.org/models_papers/papers/insurancewp.htm.

55b The premium may also represent compensation for prepayment or extension risk in the case of debt instruments that lack fixed maturities.

Chapter 2

8

The same approach can be used by a CBO issuer to create synthetic collateral. Thus, instead of acquiring loans or bonds, a CBO issuer may invest in a high-quality debt instrument and a default swap or PAYGO swap under which it sells credit protection and receives compensation. The swap would relate to reference obligations (or, in the case of a default swap, reference obligors) to which the issuer wants economic exposure in its investment portfolio. The debt instrument securing the swap may be a revolving debt instrument that allows the CBO issuer to make investments and to withdraw funds without penalty from time to time. Synthetic collateral may allow the issuer to better match the terms of its assets and liabilities. It may also allow the CBO issuer to invest in debt instruments that cannot easily be assigned, such as certain bank loans.55c Further, the periodic payments made under a default swap may include an added risk premium the owner of a debt instrument is willing to pay to divest itself of credit risk while at the same time retaining ownership of the instrument and, with it, control over voting rights and servicing.

Add the following new Part J at the end of the chapter:

J. Synthetic Variable Rate Tax-Exempt Bonds

The demand for short-term or variable rate municipal bonds (principally from mutual funds) exceeds the supply. To fill the gap, long-term fixed rate municipal bonds are often converted into synthetic variable rate tax-exempt bonds and a residual class using a two-class trust structure. The trust holds a single class of fixed rate bonds and issues two classes of ownership interests. One class (the synthetic variable rate class) is entitled to all or a portion of the principal on the bonds and interest on the principal amount (payable solely out of interest on the bonds) at a rate determined periodically by a remarketing agent to be the rate that would cause the synthetic variable rate class to have a value equal to par. The second class (the residual class) is entitled to all remaining principal and interest. The synthetic variable rate class is entitled to a portion of any gain (generally, 5 to 10 percent) from the disposition of the bonds. All remaining capital gains, all accrued market discount, and all of the losses are allocated to the residual class.

As a result of the two-class structure, the trust is not classified, for tax purposes, as a trust but rather as a partnership.61 For trusts established prior to January 1, 2004, the trust documentation typically included a statement that the parties elect out of subchapter K. Accordingly, owners of interest in such trusts have reported their shares of tax-exempt income from the bonds held by the trust as such income accrues without taking into account the timing and other substantive rules of subchapter K. In 2002 and 2003, the Service issued three revenue procedures that took the position that a trust with a preferred and residual class of ownership

55c A default swap or total return swap would also be useful where interest paid on the reference

security could not be paid free of withholding tax, for example, because the underlying debt instrument is in bearer form and was not sold under the Eurobond exception (see Chapter 12, Part C.2). However, in the authors’ experience, concern over withholding taxes has not been a major reason for using default swaps.

61 For a discussion of the classification of multiple-class trusts under the Sears regulations, see Chapter 4, Part D.5.

Chapter 2

9

interests is not eligible to elect out of subchapter K and provided some relief from the consequences of that view by, among other things, allowing a monthly closing of the books.62

62 For a discussion of the election out of subchapter K and the revenue procedures, see Chapter 5,

Part C.8 (in the book and this Supplement).

10

Chapter 3 Sale/Financing and Debt/Equity Issues

C. Tests for Distinguishing a Sale From a Financing—Overview

1. Tax Ownership

The reference in footnote 5 to section 453A(b)(1) should be replaced with section 453B(a)(1).

3. GAAP

In the last line of the carryover paragraph on page 62, insert after opinion “or other evidence of legal isolation.”

Replace footnote 22 with the following:

For a good summary and analysis of FASB 140 and related accounting issues, see Marty Rosenblatt, Jim Johnson & Jim Mountain, Securitization Accounting, Deloitte & Touche (July 2005).

In footnote 23, replace .”018” with .”01 -.02,” replace “125” with “140,” replace the reference to “Statement of Financial Accounting Standards No. 125” with “Financial Accounting Standards Board Statement No. 140” and delete the last sentence.

Replace the word “transferee” in the second sentence of the first paragraph on page 66 with “transferor.”

On the first line of page 67, delete “entirely.”

Add at the end of footnote 28:

If a transferee is not a QSPE but is a VIE, then the entity would consolidate with the person who is the primary beneficiary of the entity under the standards of FIN 46(R). For a brief summary, see Chapter 2, Part D.2 (in this Supplement).

D. Distinguishing a Sale From a Financing—Detailed Discussion of Tax Standards

1. Sources of Authority on Tax Ownership

Replace the first paragraph on page 69 with the following:

The authors have identified thirteen main groups of authorities that play a role in evaluating whether a transfer of interests in debt instruments should be recognized to be a sale (readers who can suggest other entries should feel free to contact the authors). These relate to sales of installment obligations, repos, options, guarantees, equipment trusts, pass-through certificates, leased property, conduit arrangements, short sales, the timing of sales under sales contracts,

Chapter 3

11

stranded cost financings, variable life insurance and annuity contracts, and an agent owned by its principal.

a. Installment Obligations

Add the following to footnote 30:

Another excellent discussion of tax ownership is Alex Raskolnikov, “Contextual Analysis of Tax Ownership,” 85 Boston University Law Review 431 (2005). The article reviews authorities on tax ownership and finds that they are more consistent when divided up based on whether they involve fungible or nonfungible property and the question of when or whether a transfer of ownership occurs.


In IRS Non Docketed Service Advice Review 20,250 (2002 IRS NSAR 20250 (December 2, 2002)), the Service concluded on the particular facts that a pledge of installment notes received from the sale of farm property was not a disposition of the notes.


In T.A.M. 200120001 (July 28, 2000), the Service held that automobile dealers that transferred customer notes to the taxpayer under a servicing agreement had sold them rather than having merely pledged them. The Service examined the facts in light of the list of traditional ownership factors.


TREA 1999 prohibited the use of installment reporting, with limited exceptions, for accrual method taxpayers, effective for sales occurring on or after December 17, 1999. The prohibition was repealed retroactively by the Installment Tax Correction Act of 2000, P.L. 106-573. See also Notice 2001-22, 2001-12 I.R.B. 911 (accrual basis taxpayers that sold property in an installment sale on or after December 17, 1999 may use the installment method to report gain; the installment sale rules generally should be applied as if the restriction on accrual method taxpayers had not been enacted).

b. Sale/Repurchase Agreements

Replace the citation to Revenue Ruling 77-59 in footnote 39 with the following:

Revenue Ruling 77-59, 1977-1 C.B. 196 (purchase and resale of Treasury obligations); Revenue Ruling 79-108, 1979-1 C.B. 75 (similar, with purchaser receiving compensation by keeping interest payments on obligations purchased and resold);


Revenue Procedure 2004-28, 2004-22 I.R.B. 984, allows a RIC to treat a repo that is collateralized fully with Government securities as a Government security for purposes of the RIC diversification test in section 851(b)(3) despite the status of the repo as a secured loan for tax purposes, based on an SEC rule adopted under the diversification provisions of the Investment

Chapter 3

12

Company Act of 1940 that allows look-through treatment for fully-collateralized repos. Investment Company Act definitions are relevant under section 851(c)(5).

Replace “dealer” with “insurance company” in the parenthesis after the citation to the Citizens Nat’l Bank of Waco case in footnote 41.

c. Options


The IRS has proposed rules for determining when options may be treated as partnership equity. Proposed Regulation § 1.761-3 treats a noncompensatory option issued by a partnership to acquire a partnership interest as a partnership interest (in effect as if exercised) if the option provides the holder with rights that are substantially similar to the rights afforded to a partner and, as of the date of issue, transfer or modification, there is a strong likelihood that the failure to treat the holder as a partner will result in substantial tax savings. Whether an option provides such rights depends on all facts and circumstances, including whether the option is reasonably certain to be exercised (as of the time that the option is issued, transferred or modified) and whether the option holder possesses partner attributes (generally, sharing in partnership profits or losses and control or blocking rights). An option holder generally has rights substantially similar to the rights afforded to a partner if the option is reasonably certain to be exercised. Proposed Regulation § 1.761-3 lists nine factors to consider in determining if an option is reasonably certain to be exercised, including the exercise price and term of the option and the fair market value and volatility of the partnership interest. See Proposed Regulation § 1.761-3(c)(2). The Proposed Regulation would test the certainty of exercise of an option not only upon issuance but also upon transfer. This would be a novel approach to characterizing financial instruments. See New York State Bar Association Tax Section, “Report on the Proposed Regulations Relating to Partnership Options and Convertible Securities” (January 23, 2004) (“To our knowledge, this would be the first time that the tax law would seek to alter the tax character of a financial instrument after original issuance without any change in the terms of that instrument. [footnote omitted]” In Federal Home Loan Mortgage Corp. v. Comm’r, 125 T.C. 248 (2005), the court held that nonrefundable fees paid by mortgage sellers to Freddie Mac (there was a .5 percent nonrefundable fee and a 1.5 percent fee that was refunded if the loan was sold) represented an option premium that should be accounted for as an adjustment to the purchase price of loans that were in fact purchased. The court held that there was some uncertainty as to whether a sale would occur, as evidenced by the fact that the seller was willing to pay a fee to have the right not to close (alternatively it could have entered into a fixed commitment to sell with reduced fees). Note that the arrangement was treated as an option rather than a forward contract despite the fact that only about 1 percent of the sales did not go through. For an authority holding that the existence of a put right granted in settlement of a claim against the seller of a security is not generally a current sale, see footnote 43a.

Add the following to the text at the end of section c:

A revenue procedure discusses whether the receipt, in settlement of claims against a seller of auction rate securities, of a put right combined with a right to borrow the sale proceeds from the put writer may amount to a sale of those securities.43a

43a Revenue Procedure 2008-58 (as revised September 29, 2008), provides guidance on when a holder

of auction rate securities who accepts offers to settle claims relating to those securities against

Chapter 3

13

e. Equipment Trusts and Similar Arrangements

Delete the reference in footnote 46 to P.L.R. 200046025. This ruling involves a stranded cost financing in which debt issued by a utility through a special purpose entity was combined with an interest rate swap using a trust. Stranded cost financings are discussed in Part D.1.k (in this Supplement).

f. Pass-Through Certificates

Delete the word “implicitly” in the second line from the bottom of the text on page 76.

Replace the phrase “and either must, in the case of Ginnie Mae, or may, in the case of Fannie Mae and Freddie Mac, retain the ultimate risk of credit losses” at the end of the first sentence and the entire second sentence of footnote 48 with the following:

Furthermore, while the descriptions of the facts in early rulings in this area are not clear as to whether the sponsors retained the ultimate risk of credit losses, all three agency programs clearly contemplate transactions in which the sponsor retains such risks. See Ginnie Mae MBS Guide, Chapter 5, “Issuers - Risks and Liabilities” (page last updated May 1, 2005); Fannie Mae Single Family Selling Guide, Part I, 201.02, “Special Lender Obligations” (page last updated June 30, 2002); Freddie Mac Single-Family Seller/Servicer Guide, Volume 1, Chapter 11.10 “Election to sell with or without recourse” (page last updated June 28, 2004).

another person (referred to in the ruling as “Corporation X”) will be considered to remain the owner of the securities. The settlement offer described in the revenue procedure is one under which the owner has the right (but not the obligation) to sell the securities at par to Corporation X during a window period, but otherwise retains the right to vote the securities, to sell them (subject to the mitigation right described below) and to collect income on them at a rate determined according to their terms, which may be a fluctuating rate. The securities are not redeemable on a fixed date (or only on a date at least two years later than the end of the window period). Some settlement offers may allow Corporation X to mitigate its losses by selling securities during the window period and forcing the taxpayer to sell, making up the difference between the sales price and par. A settlement offer may also allow a taxpayer to elect to borrow from Corporation X the full face amount of the security before the end of the window period, in which case the obligation to repay the loan will be secured (in form) only by the security. The revenue procedure states that the IRS will not challenge the position that a taxpayer who accepts a settlement offer continues to own the securities until they are actually sold. This guidance would be particularly helpful in cases in which it is clear that the securities are and will continue to be worth less than par so that the likelihood that a taxpayer will not elect to sell before the end of the window period is remote. Further, under general tax principles, the combination of a right of the taxpayer to sell and a right of Corporation X to buy from the taxpayer to mitigate damages could be troublesome. The revenue procedure also states that the IRS will not challenge the position that the taxpayer can essentially report no consequences from accepting the settlement offer other than to report the ultimate sale for the amount realized. Thus, for example, the IRS will not assert that the taxpayer received income upon accepting the offer (and thereby gaining the right to sell in the window period but not yet exercising it) equal to the then value of the put right. The revenue procedure applies only during certain time periods (it is one of a series of measures taken to be nice to taxpayers suffering from the credit crisis) and cautions that taxpayers should not draw inferences from it where it does not apply by its terms (e.g., in happier times when the IRS may be in a less forgiving mood). A version of the same revenue procedure released on September 23 did not apply to a taxpayer who elects to accept the cash advance. Apparently, the IRS discovered that the cash election was the most popular choice, so the restriction substantially limited the usefulness of the guidance.

Chapter 3

14

g. Leased Property


F.S.A. 200106019 (November 3, 2000) concludes, after a lengthy analysis, that a sale and leaseback of satellite transponders is a financing. The lessor was a special purpose entity created to sell tax benefits from ownership of the transponders to investors. Certain leasing transactions with tax-indifferent lessees have attracted the ire of the Service in recent years. Revenue Ruling 2002-69, 2002-2 C.B. 760, modifying and superseding Revenue Ruling 99-14, 1999-1 C.B. 835, holds that a lease-in, lease-out (LILO) transaction creates only a future interest in leased property (denying the anticipated benefits of the transaction). Notice 2005-13, 2005-9 I.R.B. 630, designated sale-in/lease-out transactions (SILOs) as listed transactions that do not achieve their anticipated tax consequences. SILOs are sale-leaseback transactions with tax-indifferent lessees in which substantially all of the lessee’s payment obligations are economically defeased and the taxpayer’s risk of loss from a decline, and opportunity to profit from an increase, in the value of the leased property are limited. In 2008, the IRS offered a settlement proposal to taxpayers participating in LILOs and SILOs that was accepted by two-thirds of the affected taxpayers. See 2008 Tax Notes Today 205-1, which has citations to the releases describing the settlement offers. Two letters to the Department of Treasury and the Service ask for guidance on a number of commercially significant leasing issues, including the treatment of re-leases of property following the end of a lease, residual value guarantees, assignments of leased property by the lessor (whether to retest the status of a lease), rent assignments (borrowings or sales), and synthetic leases. See letter dated November 29, 2006 to Eric Solomon from Leo Naughton of Deloitte & Touche LLP (attaching an earlier letter from the law firm Dewey Ballantine LLP), 2007 Tax Notes Today 4-27 (January 5, 2007).

The following replaces footnote 52 in its entirety:

Revenue Procedure 2001-28, 2001-19 I.R.B. 1156, modifying and superseding Revenue Procedure 75-21, 1975-1 C.B. 715, Revenue Procedure 76-30, 1976-2 C.B. 647, and Revenue Procedure 79-48, 1979-2 C.B. 529.

Add to the citation to Del Commercial Properties Inc. v. Comm’r in footnote 55:

aff’d, 251 F.3d 210 (D.C. Cir. 2001), cert. denied (2002).

i. Short Against the Box


In Revenue Ruling 2003-7,60a the Service ruled that a variable prepaid forward contract on stock having the terms set out in the ruling did not cause an actual sale of the stock or a constructive sale under section 1259. Under the contract, the shareholder (1) receives a fixed amount of cash upon execution of the contract, (2) agrees in three years time either to deliver a number of shares of common stock of an identified publicly traded corporation that varies significantly (between 100 and 80 as described below) based on the value of the stock at the time

60a 2003-5 I.R.B. 363. For an article raising questions about the scope of Revenue Ruling 2003-7, see

David H. Shapiro, “Taxpayer-Friendly Result in Rev. Rul. 2003-7 May Create a False Sense of Security,” Tax Notes Today 37-22 (February 24, 2003).

Chapter 3

15

of delivery, or at the shareholder’s option, to pay cash equal to the fair market value of the shares, (3) pledges 100 shares (by delivering them to a third-party trustee) to secure its delivery obligations (retaining the right to vote the pledged shares and to receive dividends), (4) has the unrestricted legal right to deliver the pledged shares or to substitute cash or other shares for the pledged shares on the delivery date, and (5) intends to deliver the pledged shares, but is not economically compelled to do so. The ruling cites cases involving transfers of shares to a brokerage firm and short sales. The first cases hold that where a shareholder transfers shares legally to a subordination account with a brokerage firm, the terms of the account allow the firm to sell shares in the account and use the proceeds to meet creditor claims if needed, the original shareholder has the right to receive dividends, vote the shares, and substitute other assets in the subordination account, and the owner has other assets that could be substituted, then there is no taxable disposition of the shares unless and until they are sold to meet creditor claims. Similarly, short sale cases support the conclusion that shares purchased with the intention of using them to cover a short sale are not sold until delivered because the taxpayer retains the right to vote and receive dividends on the shares and the right to deliver other shares to close the short. Factors supporting the lack of a sale on the facts of the ruling are that the shareholder retains the right to vote and receive dividends, title and possession of the shares are with a third party trustee and not the counterparty, and the shareholder has the right to deliver other shares. The ruling cautions that there could be a different result if the shareholder is under any economic compulsion to deliver the pledged shares (including because of restrictions on the shareholder’s right to own pledged shares after the contract termination or an expectation that the shareholder would lack sufficient resources to settle the contract using assets other than the pledged shares). The ruling also concludes that the contract does not effect a constructive sale under section 1259 on the ground that the “significant variation” (between 100 and 80) in the number of shares to be delivered prevents the contract from being a forward contract within the meaning of section 1259(d)(1), which is a contract to deliver a “substantially fixed” amount of property.

In a controversial 2005 technical advice memorandum, the Service took the view that Revenue Ruling 2003-7 did not apply (and there was a current sale of stock) when pledged shares subject to a prepaid forward contract were loaned by the forward seller to the forward buyer who disposed of them, all as part of the same transaction with the forward sale. See T.A.M. 200604033 (October 20, 2005). The IRS reasoning is further explained in Chief Counsel Attorney Memorandum, IRS AM 2007-004 (January 24, 2007). For a colorful discussion of the current state of prepaid forward contracts, see Lee A. Sheppard, “Your Government at Work on Financial Products,” 2007 Tax Notes Today 89-3 (May 3, 2007).

Before issuing Revenue Ruling 2003-7, the Service challenged the treatment of a number of similar arrangements. In 2002, the Service (or at least one examiner) took the position in an audit that gain is triggered upon the execution (rather than the settlement) of a plain-vanilla, variable prepaid forward contract. See Stevenson v. Comm’r, No. 13449-02 (T.C. filed August 20, 2002); 2002 Tax Notes Today 199-96 (August 20, 2002). It is not clear from the petition whether the Service’s position was based on general tax principles, section 1259, or both. A F.S.A. issued in 200060b holds that a hedging/monetization transaction with respect to shares representing a minority stake in a subsidiary should be treated as a current sale, despite the ability of the taxpayer to choose which shares to deliver within a fungible class. The facts involved a

60b F.S.A. 200111011 (December 6, 2000).

Chapter 3

16

mandatory physical delivery of shares (like a typical loan of securities). This advice has been widely criticized.60c

Finally, in a 2008 coordinated issue paper, the IRS held that a variable prepaid forward contract combined with a share lending arrangement entered into substantially contemporaneously between the parties to the forward contract that provides the securities borrower with possession and unlimited use of the loaned shares was distinguishable from Revenue Ruling 2003-7 and resulted in a taxable sale.60d

The paper addresses the following generic fact pattern: a taxpayer that owns appreciated stock enters into a purchase agreement to monetize its position in the stock with a counterparty, usually an investment bank. The taxpayer agrees to deliver a variable number of shares at a later date (with the option to cash-settle) and receives an up-front payment representing a significant portion of the current fair market value of the shares. The taxpayer is not required to repay any portion of the up-front payment, regardless of the value of the stock at time of settlement. The taxpayer also is entitled to receive a certain portion of any appreciation in the value of the stock (up to a specified cap), with any remaining appreciation captured by the counterparty. Under the purchase agreement, the taxpayer is required to deposit into a pledge account the maximum number of shares that may be delivered and to grant the investment bank a security interest in the shares. The investment bank generally is permitted to hedge its position by selling, pledging, rehypothecating, investing, commingling, disposing or otherwise making use of the pledged shares. The investment bank also is permitted to transfer and vote the shares but is required to pay certain distributions received on the shares to the taxpayer. While there are variations to this fact pattern, the end result in all such arrangements is to give the counterparty to a variable prepaid forward contract broad use of the pledged or loaned shares. The IRS concludes that a variable prepaid forward contract coupled with a share lending arrangement of this type results in a current taxable disposition of the shares. Revenue Ruling 2003-7 does not govern the transactions because of the transfer to the counterparty of possession and broad use of the pledged shares. Further, the nonrecognition rule for certain securities loans in section 1058 does not apply because, in violaton of the section, the transactions eliminate the taxpayer’s risk of loss with respect to the shares. The paper notes that penalties may apply depending on the particular facts and the year in question.

j. Timing of Sales


Where property is sold through an intermediary, it may be clear that the property has been sold but a further question arises whether there is one sale or two in sequence. This question comes up, for example, when an employer arranges with a relocation company (acting as agent for the employer) to buy an employee’s house for sale to a third party purchaser, with the relocation company not having a right to rescind the purchase if no third party purchaser is found. Depending on how the transaction is structured, the transaction could be viewed as either (x) two

60c It seems inconsistent with F.S.A. 199940007 (June 15, 1999), which held that a taxpayer had not

sold stock when it issued a cash-settled note (taxable as a collar) with similar economics to the transaction discussed in the later F.S.A. See also F.S.A. 200150012 (September 11, 2001) (similar economics, instrument physically settled with option of issuer to settle in cash, not a current sale).

60d Coordinated Issue Paper, Variable Prepaid Forward Contracts Incorporating Share Lending Arrangements, LMSB-04-1207-077, All Industries (February 6, 2008).

Chapter 3

17

sales—a sale of the house by the employee to the employer (through a relocation company, acting as the employer’s agent), followed by a separate sale of that house by the employer to the third party purchaser, or (y) a single sale—a sale of the house from the employee to the third party purchaser (merely facilitated by the relocation company, acting as the employer’s agent). These issues are addressed in Revenue Ruling 2005-74, 2005-51 I.R.B. 1153. It may or may not matter to the first seller which view is correct.

Add the following new sections D.1.k, l and m at the end of Part D.1:

k. Stranded Cost Financings. One type of securitization that has received considerable attention from the IRS in recent years involves the issuance of securities by a utility to finance stranded costs that arise in connection with the deregulation of the market for electricity. Typically, the securities take the form of debt and are issued (without recourse to the utility) through a special purpose entity (SPE) wholly-owned by the utility. Revenue Procedure 2005-62, which supersedes a 2002 revenue procedure, sets out tests that, if met, will assure treatment of stranded cost financings as borrowings, and not as sales of property or other events accelerating income accruals.61a The tests are described below. The IRS had previously issued at least 20 private letter rulings to the same effect.61b Ordinarily, the IRS will not issue private letter rulings on primarily factual issues (including whether an instrument is debt or equity),61c but the IRS may have been encouraged to act by other governmental agencies that wished to implement deregulation plans. Revenue Procedure 2005-62 and its predecessor were designed to avoid the need to continue issuing individual rulings.61d

Stranded costs are generation-related costs that were incurred by a regulated utility prior to a switch from a regulated to a competitive system for generating and selling electricity and are not expected to be recoverable from customers buying power at market prices. Under special state statutes, the utility is permitted to charge consumers of electricity in its service area a special charge that is due whether or not the consumer buys from the utility. Some or all of the charge (sometimes referred to as a “transition charge”) is designed to be used to support debt. In a typical transaction, the utility assigns the right to transition charges to a wholly-owned SPE in exchange for the proceeds from issuance of debt by the SPE. The debt provides for periodic interest payments and a schedule of principal payments. The debt may be a single class or

61a 2005-37 I.R.B. 507, superseding Revenue Procedure 2002-49, 2002-2 C.B. 172. Strictly speaking,

Revenue Procedure 2005-62 (like the prior rulings referred to below) treats the securities issued in the financing as “obligations of the utility” and not specifically as indebtedness, although that is the clear intent.

61b The first rulings, for California utilities, were P.L.R.s 9750017 and 9750018 (both dated September 8, 1997). More recent rulings are: P.L.R.s 200217052 (January 29, 2002), 200147022 (July 31, 2001), 200110022 (December 7, 2000), 200107017 (November 15, 2000), 200102044 (October 17, 2000), 200101023 (October 4, 2000), 200046025 (August 18, 2000), 200026015 (March 31, 2000), 200020043 (February 18, 2000), 200020045 (February 18, 2000), 199942020 (July 23, 1999), 199942019 (July 23, 1999), 199937040 (July 9, 1999), 199930030 (April 29, 1999), 199906021 (November 13, 1998), 9853020 (January 4, 1999), 9852048 (December 24, 1998), and 9814007 (December 19, 1997).

61c See Section 4.02(1) of Revenue Procedure 2006-3, 2006-1 I.R.B. 129. 61d To make that point explicit, Revenue Procedure 2005-61, 2005-37 I.R.B. 507, states that the

Service will no longer issue rulings relating to the realization of income by an investor-owned utility upon the creation, transfer or securitization of intangible rights under cost recovery legislation.

Chapter 3

18

divided into classes with staggered maturities, with the longest classes having a legal final maturity date in the range of 10 to 15 years after issuance. Transition charges are used to pay expenses of the SPE and are then applied to pay interest, to pay principal up to scheduled amounts, and to build up reserves. If the rates charged to consumers are too high or too low compared with the items to be funded, the rates for transition charges are adjusted periodically to bring in the scheduled amounts. In addition to the adjustment mechanism, there may be credit enhancement in the form of a small capital contribution to the SPE by the utility (e.g., one-half percent of the principal amount of the bonds) and reserves built up out of excess revenues (typically accumulating to one-half percent of the original principal amount).61e Furthermore, collections of transition charges in excess of amounts needed to pay scheduled principal and interest are retained by the SPE in a special reserve account rather than paid through to investors. The utility collects the transition charges as a servicer on behalf of the SPE (subject to being replaced upon a servicer default). The SPE’s debt is typically AAA rated (i.e., has virtually no risk of default).

The SPE is a domestic LLC or other unincorporated entity that does not elect to be a corporation and is therefore disregarded as a branch of the utility. Accordingly, the transfer of the right to receive transition charges from the utility to the SPE is a tax nothing, and the arrangement amounts to an issuance of nonrecourse debt of the utility secured by the transition charges. Normally, highly-rated debt of a corporation backed by a stream of operating revenues of the corporation would clearly be recognized to be debt of the corporation and not an ownership interest in the revenues.61f A stranded cost financing is a more difficult case because the transition charges represent a separately identifiable class of revenues that substantially match debt service and related costs and are not dependent on the general performance or creditworthiness of the utility. The utility could go out of business, and the transition charges would still be collected based on power sales by someone else. The explicit state law treatment of the transition charges as property rights that can be assigned away from the utility also is an unhelpful factor.61g These considerations plus the fear of large numbers led tax advisors of the utilities to seek the IRS rulings described above.

61e Revenue Procedure 2005-62 requires a minimum initial capitalization of 0.50 percent of the

principal amount of the bonds issued. It does not require any additional build-up of reserves. 61f Indeed, in cases where taxpayers with expiring net operating losses have attempted to accelerate

income by “selling” rights to future operating revenues, several courts have frustrated the scheme by recharacterizing the transactions as loans. Two key factors have been that the buyer was virtually guaranteed a return of the amount invested plus an interest factor and the seller retained control over the business that generated the revenues and was required to continue generating revenues until the buyer was repaid (in other words, the buyer purchased a right to cash in identified amounts rather than a right to identified receivables that may or may not have produced the required cash). See Mapco Inc. v. United States, 556 F.2d 1107 (Ct. Cl. 1977) and cases cited therein.

61g Section 636 treats production payments representing rights to fixed cash amounts (with or without an interest factor) representing an economic interest in oil and gas or other mineral properties as a loan on the property. Prior law, however, had treated sales of production payments as taxable sales (specifically, anticipatory assignments of rights to future income). See Comm’r v. P.G. Lake, Inc., 356 U.S. 260 (1958). Sale treatment arose from the local-law treatment of production payments as partial interests in mineral property that could be separately owned. It is not surprising, then, that a farmer selling a right to a fixed dollar amount of future crop revenues could not rely on the mineral precedents because of the different property law treatment of crops and minerals. See Bryant v. Comm’r, 399 F.2d 800 (5th Cir. 1968).

Chapter 3

19

Revenue Procedure 2005-62 applies to investor-owned public utility companies that, pursuant to “specified cost recovery legislation,” receive an irrevocable financing order from an appropriate state agency determining the amount of certain specified costs the utility will be permitted to recover through a “qualifying securitization” of an intangible property right created by the specified legislation. There is a definition of specified cost recovery legislation that describes the typical terms of such legislation (including a procedure for perfecting a transfer of the right to specified charges as an absolute sale). A qualifying securitization is defined as an issuance of bonds, notes, or other evidences of indebtedness or certificates of participation, or beneficial interests that are secured by the right to collect specified charges and other assets of the financing entity and provide for quarterly or semiannual payments, where the financing entity is wholly-owned, directly or indirectly, by the utility, and is initially capitalized by the utility with at least 0.5 percent of the total principal amount of the non-equity securities issued. If the revenue procedure applies, (1) the utility will not recognize gross income upon the receipt of a financing order creating a right to specified charges, the transfer of that right to a financing entity, or the receipt of proceeds of securitized instruments issued by the financing entity, (2) the securitized instruments will be treated as obligations of the utility, and (3) the utility will include the specified charges in gross income under its usual method of accounting. Revenue Procedure 2005-62 seeks to limit its use as precedent by stating that specified charge statutes are unique to the regulated utility industry, so that the law and analysis applied to specified charge financings are peculiar to them.

l. Variable Life Insurance and Annuity Contracts. Life insurance and annuity contracts offer tax benefits in the form of tax-deferred inside buildup (the ability to accumulate earnings within an insurance company on a tax-free basis until actual receipt by the policyholder) and an exclusion of death benefits under a life insurance policy from gross income. Insurance companies offer variable life insurance and annuity products that are intended to provide these tax benefits while at the same time permitting amounts invested in the policy to be invested in a segregated pool of investment assets over which the policyholder has investment discretion. The policyholder has only a contractual claim against the insurance company and not a security interest or local-law ownership interest in the assets. However, the insurance company is required to hold identified assets in a segregated account relating to the policies.

There is a substantial body of law, consisting of revenue rulings and cases, addressing when the investor has sufficient control over, or other incidents of ownership in, the related investment assets so that it is treated as the owner of those assets for tax purposes (resulting in a denial of the tax benefits accorded to insurance products).61h Revenue Ruling 81-225 concerned investments in

61h See, e.g., Revenue Ruling 81-225, 1981-2 C.B. 12, modified by Revenue Procedure 99-44, 1999-2

C.B. 598 (described below in the text); Revenue Ruling 80-274, 1980-2 C.B. 27 (depositor/holder of annuity contract, the proceeds of which are invested in deposits in a savings and loan association, treated as the owner of the deposits); Revenue Ruling 77-85, 1977-1 C.B. 12 (holder of annuity contract treated as owner of investment assets held in a custodial account consisting of bank deposits or publicly-traded securities on an approved list, where holder had the right to direct sales and purchases of account assets, had the right to direct any votes with respect to account securities and, through the annuity contract, had the benefit and burden of changes in value of account assets). The “investor control” doctrine of Revenue Ruling 81-225 was upheld in Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1984). For a good recent discussion of the authorities in this area, including the hedge fund rulings described in the text and footnote 61k below, see Deborah M. Beers, “New Guidance on Structuring ‘Hedge Fund’ Investments Within Variable Life and Annuity Contracts,” Tax Management Memorandum, Vol. 35, February 9, 2004.

Chapter 3

20

mutual funds pursuant to deferred variable annuity contracts. It held that the policyholder was considered the tax owner of the underlying mutual fund shares where those shares were available for purchase directly or indirectly by members of the general public (other than through the purchase of an annuity contract), but not where the mutual fund shares were available only through the purchase of an annuity contract.

In 1984, Congress enacted section 817(h), which requires that investments in a segregated asset account backing a variable annuity or life insurance contract meet a diversification test in order for the contract to be treated as an annuity or life insurance contract (or endowment contract) for tax purposes.61i The Service has taken the view that satisfying the diversification test does not prevent a contract holder’s control of the investments of a segregated asset account from causing the contract holder to be treated as the owner of the assets in the account. Recently, in Revenue Ruling 2003-92, the “investor control” doctrine was applied to treat a contract holder as the owner of underlying hedge fund partnership interests where those interests were available for purchase by investors directly on a private placement basis, notwithstanding that the partnerships were treated as look-through entities for purposes of the diversification test in section 817 and accompanying regulations. Shortly following the issuance of this ruling, the Service also issued proposed regulations (which have since been adopted) to conform the regulations applying the section 817 diversification test to the position adopted in the ruling.61j

m. Agent Owned by Principal. In any case in which one party has legal ownership of property and another has the economic benefits and burdens of the property, the normal tax result is to treat the second party as the tax owner. One way to describe the relationship between the two is that the legal owner holds title to the property as agent for the true owner.

One setting in which the normal principles governing tax ownership do not apply is where property is owned legally by an entity and the party claiming tax ownership is the owner of the entity. To illustrate, suppose a corporation is owned by a single shareholder. The corporation holds a parcel of real property and nothing else. Economically, the benefits and burdens of the real property are with the shareholder. However, it cannot be that the shareholder is therefore the tax owner of the real property. Concluding that shareholders are the tax owners of corporate property because they have the benefits and burdens of the property would be equivalent to denying the separate existence of the corporation. That is not the usual approach. The much-cited Moline Properties case stands for the proposition that corporations usually are treated as separate entities for tax purposes.61k Perhaps the best way to describe the corporation-shareholder structure is that there are two owners of distinct property (the underlying property and the corporate stock) having in the aggregate the same economic traits.

61i See also Treasury Regulation § 1.817-5. 61j Specifically, the proposed regulation would remove Treasury Regulation § 1.817-5(f)(2)(ii) which

requires taxpayers to look through an interest in a non-registered partnership in applying the section 817 diversification test. The proposed regulation was adopted by T.D. 9185, 2005-12 I.R.B. 749. Revenue Ruling 2007-7, 2007-7 I.R.B. 468, holds that the holder of a variable annuity or life insurance contract is not treated as the owner, for federal income tax purposes, of an interest in a regulated investment company that funds the variable contract solely because interests in the same regulated investment company are also available to investors described in Treasury Regulation § 1.817-5(f)(3).

61k Moline Properties v. Comm’r, 319 U.S. 436 (1943).

Chapter 3

21

The application of the Moline Properties principle to a fact pattern in which the shareholder of a corporation seeks an advantage from treating the corporation as a mere agent for tax purposes has been considered in two Supreme Court decisions, National Carbide61l and Bollinger.61m National Carbide involved three subsidiaries that agreed to operate their production facilities as an “agent” for their parent. They would distribute all profits to the parent other than a small fee and only reported income in the amount of the fee. The court rejected the argument that these subsidiaries were the mere agent of their parent, and held that they should be taxed under the separate-entity doctrine of Moline Properties. However, the court noted that in certain limited circumstances, there could be such a thing as a “true corporate agent.” The court provided a six-factor test for determining whether a true agency agreement existed. The factors are: (1) whether the corporation operates in the name and for the account of the principal, (2) whether it binds the principal by its actions, (3) whether it transmits money received to the principal, (4) whether the receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal, (5) whether the corporation’s relationship with its principal is dependent upon the fact that it is owned by the principal, and (6) whether the corporation’s business purpose is the carrying on of the normal duties of an agent.

In Bollinger, the taxpayer was a partnership that formed a corporation in order to obtain a mortgage on property at an interest rate higher than was permitted by Kentucky usury laws. The partnership sought to deduct losses sustained in the development and operation of the property on the theory that it was the true owner of the property, and the corporation merely held the property as an agent for the partnership. The IRS disallowed these losses, reasoning that the corporation was a separate entity and the relationship did not meet the requirements for an agency relationship laid out in National Carbide. The IRS argued that the corporation’s business purpose was not carrying on the normal duties of an agent with respect to the property since it was acting as owner of the property for purposes of Kentucky usury laws. Moreover, the requirement that a corporate agent’s relationship with its principal not be based solely on the principal’s ownership of the corporation could not be met without arm’s-length bargaining and the payment of an agency fee. The Supreme Court, however, held in favor of the taxpayer, finding that the purpose of the separate-entity doctrine is not subverted so long as three conditions are met (which they were in the case): (1) the fact that the corporation is acting as an agent with respect to a particular asset is set forth in a written agreement at the time the asset is acquired; (2) the corporation functions as an agent and not a principal with respect to the asset for all purposes; and (3) the corporation is held out as an agent and not the principal in all dealings with third parties.

Clearly, in applying tax ownership standards, there is no general requirement that the status of the legal owner of property as agent for the economic owner be spelled out in a written agreement and pasted on billboards. The basic rule is that economics control despite a contrary form. The Bollinger test can best be understood as an additional requirement that must be met where there is a need to distinguish two equivalent economic positions with different tax consequences, direct ownership of property and ownership of equity in an entity owning property. Although Bollinger arose in a corporate context, it has been relied upon in the case of partnerships. See, e.g., FSA 200103051 (January 19, 2001) (under an alternative resolution, a partnership was treated as holding assets as an agent of its partners).

In ASA Investerings Partnership, the court, in a tax shelter setting, in determining if the relationship between a corporate taxpayer and a foreign bank was a partnership, chose to 61l National Carbide Corp. v. Comm’r, 336 U.S. 422 (1949). 61m Comm’r v. Bollinger, 485 US 340 (1988).

Chapter 3

22

disregard two thinly capitalized shell corporations that were established to serve as the nominal partners where the corporations functioned as conduits for the bank. Somewhat surprisingly, the court cited Bollinger (a “cf.” cite) as support.61n

2. Transaction Patterns

d. Prepayment and Market Value Guarantees

T.A.M 200611032 (November 2, 2005) holds that a sale by a corporation to a controlled but not consolidated subsidiary of receivables representing payment for goods sold by the corporation should be recognized as a sale (producing a loss) where the receivables were subject to cancellation if the goods were returned. Upon a return, the corporation would keep the retained goods and the subsidiary would suffer the full loss. The IRS could have taken the view that the receivables were not sold because the selling corporation retained a valuable right connected with the receivables (the right to returned goods if the receivables were cancelled). The T.A.M holds that the existence of the return contingency does not prevent the receivables from coming into existence because, under established practice, the receivables must be accrued despite the risk of a return. In effect, the T.A.M equates the magnitude of a contingency needed to prevent accrual with the magnitude of a contingency needed to prevent a sale. The T.A.M requires the selling corporation to allocate its basis in the receivables between the right to the returned goods and the right to payment.

In footnote 83, replace the citation to Revenue Procedure 2000-3 with Revenue Procedure 2008-3, 2008-1 I.R.B. 110.

E. Debt/Equity Issues

1. Overview of Tax Standards for Classifying Financial Instruments as Debt


For a discussion of the issue in the context of partnerships, see J. William Dantzler, Jr., “Debt vs. Equity in the Partnership Context,” 2006 Tax Notes Today 20-37.

Add the following new footnote 102a at the end of the second full paragraph on page 102:

For a good discussion of the income tax characterization of hybrid securities−securities with characteristics of both debt and equity (or debt and some other financial instrument, such as an option or forward contract)−see Louis S. Freeman and Matthew A. Stevens, “Tax Consequences of Business and Investment-Driven Uses of Financial Products” in Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2005 (Practising Law Institute).

Revenue Ruling 2008-1, 2008-2 I.R.B. 248, holds that a prepaid forward contract on a single foreign currency that is issued and redeemed in U.S. dollars is debt for federal income tax purposes, despite the fact that the amount of U.S. dollars received at maturity may be less than the amount invested. In this case, the legal remedies available to the investor under the instrument

61n ASA Investerings Partnership, AlliedSignal Inc., Tax Matters Partner v. Comm’r, T.C. Memo

1998-305, aff’d 201 F.3d 505 (D.C. Cir. 2000), cert. denied, 531 U.S. 871 (2000).

Chapter 3

23

are similar to those available to holders of debt instruments and the investor’s return on the contract is similar to the return on a debt instrument denominated in the relevant foreign currency. In general, nonfunctional currency is considered to be “property” for U.S. federal income tax purposes. Thus, an instrument that provides a return based on the value of foreign currency may have sufficient variability to support a characterization as something other than a debt instrument. However, under section 988, nonfunctional currency is treated like money for purposes of determining the amount and timing of interest that accrues on debt, and the return on the instrument in question was determined by the value of foreign currency at issuance and maturity, and market interest rates relating to that foreign currency.

In a companion to the ruling, Notice 2008-2, 2008-2 I.R.B. 252, the IRS requests comments on prepaid forward contracts that are not treated as debt for federal income tax purposes. Prepaid forward contracts generally resemble traditional forward contracts except that the purchase price is paid in advance of future delivery of the property (or cash settlement). In particular, the Notice asks for comments on: the methodology for accruing income and expense, if appropriate; the appropriate character of any income accruals, as well as the treatment of any amounts in excess of, or less than, the accruals; whether the nature of the underlying property or whether the instrument is traded on a futures or securities exchange should affect the tax treatment; whether the instruments should be treated as debt pursuant to section 7872; whether section 1260 applies; if and how such contracts should be taxed under sections 871 and 881; the treatment of income from the contracts under section 954; and the treatment of investments in such contracts under section 956.


F.S.A. 200130009, the advice discussed in Part E.2.c.(iv) (in this Supplement) that treats a plain vanilla issuance of pay-through bonds as a sale, lumps together sale/financing and debt/equity issues, which may be one reason why it went off the rails. Revenue Procedure 2002-49 provides safe harbor rules for determining when debt issued in a stranded cost securitization will be recognized to be debt of the sponsor utility but includes no analysis of the issues. See Part D.1.k (in this Supplement).


There are only limited authorities addressing how traditional debt/equity criteria might apply to determine if a security issued by a securitization vehicle should be classified as debt or equity of the issuer.106

2. Significance of Thin Capitalization and Asset/Debt Mismatches

b. High-Quality Receivables and Parity Classes

106 See the discussion of the NIPSCO and Principal Life cases below. By contrast, as discussed in

Part D, there are many authorities considering whether transfers of receivables to a financing party should be viewed as a sale or a pledge. F.S.A. 200130009, the advice discussed in Part E.2.c.(iv) (in this Supplement) that treats a plain vanilla issuance of pay-through bonds as a sale, lumps together sale/financing and debt/equity issues, which may be one reason why it went off the rails. Revenue Procedure 2005-62 provides safe harbor rules for determining when debt issued in a specified cost recovery securitization will be recognized to be debt of the sponsor utility but includes no analysis of the issues. See Part D.1.k. (in this Supplement).

Chapter 3

24


In the large body of tax authorities addressing the recharacterization of debt, there appear to be very few involving a similar combination of facts. The NIPSCO and Principal Life cases described below are helpful in addressing the significance of thin capitalization but do not involve traditional securitizations.112

(ii) The NIPSCO case

Replace the heading and the first sentence that follows with the following:

(ii) The NIPSCO and Principal Life cases: While there are no authorities directly on point, two recent cases shed some light on the significance of equity for a debt issuer holding other debt instruments that are expected to service its debt.

The first case,

Add the following at the end of footnote 118.

For another case casting doubt on the importance of debt/equity ratios in determining the characterization of an instrument, see Delta Plastics, Inc. v. Comm’r, T.C. Memo 2003-54 (2003).


The Principal Life Insurance case123a did not involve a securitization but nonetheless raised a question as to the treatment of debt issued by a thinly capitalized bankruptcy-remote entity holding debt as assets. In brief, Principal entered into a transaction with Prudential, another insurance company, in which each sold mortgage loans to the other in exchange for installment notes with matching terms (the obligation to pay the Prudential notes was immediately assumed by Prudential subsidiaries). Principal had a large gain on the sale and wished to defer tax without incurring the interest charge that normally accompanies deferral under the installment sale rules. To achieve this result, it “sold” the Prudential notes to a newly organized, wholly owned corporation (Newco) in exchange for the assumption by Newco of the obligation to pay a matching amount of Principal notes. The assumption effected a novation, releasing Principal from further liability on the assumed debt. Principal took the position that as a result of the sale, gain was no longer deferred under the installment sale rules (avoiding the interest charge) but was instead deferred under the consolidated return, deferred intercompany sale rules (which impose no interest charge). After some uncertainty about how best to mount an attack, the Government asserted that there was no sale to Newco, but rather a section 351 transfer of property for Newco stock that did not end deferral under the installment sale rules. That argument was somewhat difficult to make given that Principal did not take back debt of Newco but rather had its own debt assumed.

Newco was capitalized with $1 million and the debt sold to Newco had a face amount of over $525 million. Thus, Newco had a very high debt-to-equity ratio. Newco’s charter limited its commercial activities to participating in the acquisition of Prudential notes and assumption of Principal debt. The parties assumed that Newco served a business purpose in protecting

123a Principal Life Insurance Company v. United States, 70 Fed. Cl. 144 (2006).

Chapter 3

25

Prudential against Principal credit risk, although that risk could of course have been avoided through a cash sale with offsetting amounts or perhaps by a pledge by Principal of the Prudential notes back to Prudential.

The court looked to authorities considering whether a purported sale to a controlled subsidiary could be recast as a section 351 exchange and listed a number of relevant factors. One of these was whether the corporation was thinly capitalized, as reflected, for example, by a high debt-to-equity ratio. The court acknowledged that it was dealing with something new: “Because the distinction between paradigmatic debt and paradigmatic equity has been blurred by the rapidly evolving use of hybrid instruments combining debt and equity features, as well as special-purpose securitization vehicles, the need for careful evaluation now is greater than ever.”123b After such an evaluation, the court concluded that Newco was in fact adequately capitalized given the nature of its assets and restricted activities: “[R]ealistically speaking, how much entrepreneurial risk was occasioned by having [Newco] hold a relatively static group of assets and obligations, assiduously designed to have matching cash inflows and outflows?”123c The court also took some comfort from the fact that the assumed debt had in fact been timely paid. Curiously, the Government did not argue that the transaction might be viewed as a disposition by Principal of the Prudential notes back to Prudential rather than to Newco or that there was no business purpose for the issuance of mutual installment obligations.

While the case does not involve a traditional securitization and the Government seems to have had some difficulty framing the issues, it is a helpful authority supporting the view that thin capitalization of an entity is not inadequate capitalization if debt liabilities are realistically expected to be repaid from a static pool of debt assets.

(vii) Summary and intentional mismatches for nonbelievers.

Replace the citation to Revenue Procedure 2000-3 in footnote 135 with “Revenue Procedure 2006-3, 2006-1 I.R.B. 128.”

c. Lower-Grade Receivables and Junior/Senior Classes

(iii) If equity is needed, how much is enough?

Replace the third sentence of the last paragraph beginning on page 123 with the following:

IRS guidelines for stranded cost financings require equity capital of only one half percent (implying a debt-to-equity ratio of 199-to-1). However, the guidelines indicate that those financings and the related tax analysis are unique.152a The Bush 2004 Revenue Proposals included safe-harbor debt-to-assets ratios to be used in applying revised earnings stripping rules under section 163(j). (That section limits deductions for interest on debt owing to or guaranteed by tax-exempt parties related to the borrower. It does not apply if debt does not exceed safe harbor levels.) The safe-harbor debt-to-assets ratios for government securities, receivables, mortgages, and trade receivables were 0.98, 0.95, 0.9, and 0.85, respectively.152b It is likely that

123b 70 Fed. Cl. 151. 123c 70 Fed. Cl. 163. 152a See Revenue Procedure 2005-62, discussed in Part D.1.k, above (in this Supplement). 152b See Bush 2004 Revenue Proposals, 105. The proposal was dropped in later budgets.

Chapter 3

26

the guidelines were thought to be somewhat conservative, because meeting them would have produced a benefit for a taxpayer.

Add the following at the end of the carryover paragraph on pages 124 and 125:

In November 2001, U.S. federal bank and thrift regulators adopted a number of changes to the rules governing bank capital requirements in connection with asset securitizations.156a The changes were generally effective January 1, 2002. Much of the attention of the rules is focused on increasing capital charges for residuals. They also, however, create a new system for assigning different risk weightings to certain categories of asset-backed securities (other than IOs) with a credit rating of at least BB that ties the risk weighting to the rating. The weighting ranges from 20 percent for a AAA or AA rated class to 200 percent for a BB rated class. (A 100 percent rating implies a requirement to hold 8 percent capital against an asset.) Certain IO strips will require dollar-for-dollar capital or, if they exceed a new 25 percent of Tier 1 capital concentration limit, must be deducted from Tier 1 capital.


Treasury Regulation § 1.882-5T(c)(4) changes the fixed ratio to 95 percent (implying equity of 5 percent), effective for taxable years for which the original tax return due date is after August 17, 2006.

Add the following at the end of Part E.2.c.

(iv) F.S.A. 200130009. In F.S.A. 200130009 (April 27, 2001), the IRS treated a plain vanilla securitization of subordinated mortgage loans effected through the issuance of pay-through bonds by a special purpose entity holding the loans, as a sale of the loans and not a financing. More specifically, the advice recharacterized the debt issued by the special purpose entity as equity in the issuer. This holding is not supported by the reasoning set out in the advice, and the authors understand that senior IRS personnel have expressed the view privately that the advice is wrong.161a The taxpayer seems to have brought the problem on itself by reporting the transaction as a sale in its tax return and later changing course. The advice is summarized below.

A bank (“Bank”) placed mortgages in a trust (“Trust”) that issued four classes of sequential-pay notes (“Notes”) and Class A and Class B Instruments. The Notes and the Class A Instruments were interest bearing and had a specified principal amount. The Class B Instrument, which had neither an interest rate nor a principal amount, was entitled to all of the Trust’s assets after satisfaction of the Trust’s obligations under the Notes and the Class A Instruments. The Notes and Class A Instruments were overcollateralized in that the rate of interest and aggregate principal amount of the mortgages exceeded the rates on and aggregate principal amount of the Notes and Class A Instruments. Thus, absent defaults, the mortgages would create cash flows in

156a See 66 Fed. Reg. 59614 (November 29, 2001). 161a Debt/equity and tax ownership questions are highly factual, and the F.S.A. in the form released

does not include specific information regarding the risk of nonpayment of the Notes (see the text below). The Notes were rated, but the ratings were redacted from the F.S.A. as released. As a result, the description is not sufficient to form a firm conclusion as to whether there is any real doubt regarding the tax status of any of the classes of Notes (particularly the most subordinated ones). The advice, however, does not rely on credit risk as a reason for treating the Notes as equity.

Chapter 3

27

excess of the amounts needed to pay principal and interest on the Notes and Class A Instruments. Principal payments received were passed through as principal on the Notes and Class A Instruments (resulting in some build-up over time). Spread arising from the excess of interest receipts over interest expense would be paid out as principal on the Notes until certain overcollateralization targets were met and otherwise would be distributed on the Class B Instruments. Interest and then principal would be allocated among the four classes of Notes in order (from most senior to most junior), with no principal being paid on a class until the more senior classes had been retired. The Notes and Class A Instruments were offered for sale in a private placement and were distributed to underwriters (the Bank retained the Class B Instruments). However, the Bank ended up purchasing the junior-most class of Notes and the Class A Instruments.

Under the transaction documents, all holders of the Notes and Class A Instruments were deemed to agree to treat them as debt and partnership interests, respectively. Since the Bank expected to sell the Class A Instruments, it appears that the Bank intended to treat the transaction as a sale of a portion of the mortgages equal to the portion of the equity represented by the Class A Instruments.161b Given that the Bank ended up retaining the Class A Instruments, the Trust should have been treated as a disregarded entity and the Notes should have been treated as debt of the Bank (with no sale of mortgages). The advice found that the benefits and burdens of ownership of the mortgages had passed to the Trust, as they had. However, instead of finding that the Notes were indebtedness of the Trust (and hence of the Bank as owner of the Trust), the advice concluded that the Notes (as well as the Instruments) were equity in the Trust. Accordingly, the advice classified the Trust as a partnership owned jointly by the Bank and Note holders, with the result that the transfer of mortgages to the Trust involved a partial sale.161c

The F.S.A. states that whether there was a sale of the mortgages depends on an analysis of various factors. The most important ones related to intent, matching of payments, restrictions on Bank’s operations, the power of disposition, and the allocation of economic risks and potential for gain.

Regarding intent, the documentation described the transfer of mortgages by the Bank to the Trust as a sale. The existence of a transfer between the Bank and the Trust, however, says nothing about whether there is a sale between the Bank and Trust, on the one hand, and the Note holders. The private placement memorandum characterized the Notes and Class A Instruments as debt and partnership interests, respectively, for federal income tax purposes.

The Bank initially reported the transfer as a sale on its tax return (apparently of all of the mortgages). The reason may be that the personnel at the Bank responsible for filing the Bank’s tax return were not aware that the Class A Instruments had been retained. On the other hand, even if the Class A Instruments had been sold, there should have been only a partial sale.

161b For a discussion of the treatment by a sponsor of the conveyance of assets to a partnership and a

sale of partnership interests as a partial sale of assets, see Chapter 15, text following footnote 30. 161c The Bank represented that a significant proportion of the subordinated mortgages transferred to

the Trust were not “real estate mortgages” for purposes of the TMP rules, so that the Trust would not be classified as a TMP (and hence a corporation). This may have been true on the ground that the mortgages either were not adequately secured by real property or were seriously impaired (for a discussion of the TMP definition of real estate mortgage, see Chapter 4, Part E.2.a).

Chapter 3

28

The Notes were repaid solely out of collections on the mortgages, and principal on the mortgages was passed through as principal on the Notes and Class A Instruments. The F.S.A. noted that a significant part of the collections would be paid through to the Bank in its capacity as holder of the junior-most class of Notes and Class A Instruments.

There were no restrictions placed on the Bank consistent with it being a borrower. The F.S.A. does not point out that those restrictions would not be expected in a nonrecourse financing in which the borrower is legally isolated from the Bank.

The Bank lost the ability to dispose of the mortgages by transferring them to the Trust and pledging them to secure the Notes. A limitation on the power to dispose of collateral is again common in a nonrecourse financing.

Regarding the risk of loss and opportunities for gain, the advice identifies two significant economic characteristics of the mortgages, credit risk and prepayment uncertainty. Credit risk was mostly allocated to the Bank through its ownership of the junior-most securities. By contrast, a large part of the prepayment risk/opportunity was passed through to Note holders other than the Bank.

The advice concluded that the above factors (aside from the allocation of credit risk) supported the conclusion that the Notes should be treated as equity. The most important factors were the characterization of the transfer as a sale, the correspondence of payments to the Note holders with payments on the mortgages, and the pass through of prepayments. According to the advice, it was

clear that the Holders other than the Bank (i.e., the holder of the [three most senior classes of Notes]) have obtained many of the economic benefits and burdens of ownership of the pool of subordinate mortgage loans. The transfer of a substantial portion of the benefits and burdens of ownership of property is not characteristic of a financing. Thus, the transactions constitute the sale of a part of the Bank’s interest in the mortgage loans. Cf. § 301.7701-4(c)(2), Example (1) (state law “trust” that holds mortgage loans and issues senior and subordinated tranche is an “association” or partnership rather than grantor trust for tax purposes; thus, tranches represent equity interest in entity).

The reference to Example 1 in the Sears regulations is not very persuasive because that example involved a trust that issued multiple classes of sequential-pay pass-through certificates (not debt).

The argument for equity treatment in the advice would apply with equal force to virtually all pay-through bonds because they typically are payable from cash flows on the underlying receivables and prepayments are passed through. Indeed, the argument for treating the Notes as debt on the facts of the advice are very likely stronger than in a traditional pre-1987 offering of CMOs because the Bank had to retain substantial equity to absorb anticipated default losses and there was very likely a significant mismatch between the rates of interest on the underlying subordinated mortgages and on the Notes.161d The view that the pass-through of prepayments is a significant equity factor is hard to reconcile with the existence of section 1272(a)(6) (PAC

161d As discussed in Part E.2.b, a typical CMO issuer had a small amount of equity only as a sacrifice

to the tax gods and not because it was needed economically.

Chapter 3

29

method), which was enacted in 1986 to clarify how OID should be accrued on debt instruments with pay-through features.

4. Equity Interests Treated as Debt


In a 2001 F.S.A., the IRS assumed (albeit, without discussion) that the securitization of credit card receivables by a bank sponsor through the issuance of equity securities by a trust was a financing, with the receivables continuing to be owned by the bank that retained the residual interest in the trust. See F.S.A. 200136010 (June 1, 2001).

Add the following new footnote 197a at the end of the first full paragraph on page 141:

In T.A.M. 200419001 (December 5, 2003), the IRS held that there was no violation of the consistency requirement under section 385(c)(1) where a U.S. parent’s investment in a foreign subsidiary was designated as long term debt for purposes of foreign tax and capital flow restrictions, but the U.S. parent consistently treated the investment as equity for U.S. federal income tax purposes in its own tax returns and in the information returns filed with respect to the foreign subsidiary. The IRS noted that section 385(c)(1) is concerned with the U.S. federal income tax characterization of an instrument.


In Boca Investerings Partnership v. U.S., 167 F. Supp. 2d 298 (D.D.C. 2001), rev’d on other grounds, 314 F.3d 625 (D.C. Cir. 2003), involving a similar tax shelter transaction, the court recognized a purported partner to be a partner where the court found that there were no side agreements insulating the taxpayer from the economic fortunes of the partnership and placing it in the economic position of a lender.

Add the following at the end of the sentence including footnote 202:

Another case that distinguished Hunt is Castle Harbour.202a The case held that purported equity interests in a partnership held by two Dutch banks were not equity under the totality-of-the-facts approach to testing the existence of a partnership set out in Comm’r v. Culbertson.202b The partner in addition to the banks was a domestic subsidiary of General Electric Capital Corporation. The domestic partner sought to divert significant taxable income to the banks (which were not taxable in the United States on the income) relying on technical partnership income allocation rules. The income was noneconomic as to the banks. The case held that the allocations were not effective because the banks were not partners. The court thought the banks’ partnership interests strongly resembled secured debt. Those interests appeared to have an open-

202a TIFD III-E, Inc. v. United States, 2006 USTC Par. 50,442 (CCH) (2d Cir. 2006), reversing a

District Court decision. Castle Harbour is the name of the partnership and the case is generally referred to by that name. The taxpayer has filed a petition requesting a rehearing. See 2006 Tax Notes Today 188-17 (September 18, 2006). According to newspaper reports, the IRS is attacking transactions involving a similar tax strategy entered into by Merck and Dow Chemical. See “How Merck Saved $1.5 Billion Paying Itself for Drug Patents,” by Jesse Drucker, Wall Street Journal, September 28, 2006.

202b 337 U.S. 733 (1949).

Chapter 3

30

ended profit participation right as in Hunt. The court concluded, however, that the right was practically meaningless and therefore should be disregarded in characterizing the interests. The court’s decision was strongly influenced by the existence of special safeguards that gave the banks an “ironclad” right (more than just a reasonable assurance) to get back their investment and earn a return thereon even if the partnership performed badly. Those safeguards included a requirement that the partnership hold short-term, high-grade debt sufficient to retire the banks’ partnership interests and a contractual guarantee by GECC.202c Note that although the court found that partnership interests held by the banks strongly resembled debt, the court did not explicitly hold that those interests were in fact indebtedness for all tax purposes. This is implied by the court’s remand to determine whether section 704(e)(1) (a person is recognized as a partner if he owns a capital interest in a partnership in which capital is a material income producing factor) applied to the partnership interests.


F.S.A. 200034010 (May 22, 2000) analyzes preferred stock issued by a REIT in a fast-pay stock structure and concludes it is equity despite some similarities to debt. The Service noted that the preferred stock lacked certain characteristics common to debt, such as providing for the payment of a sum certain at maturity and the right of the holders to compel payment of principal and interest. Further, the preferred stock was issued, in form, as equity and was treated as equity for financial accounting purposes.

Add the following at the end of the text accompanying footnote 208:

The accounting profession has decided to treat mandatorily redeemable stock as a liability for financial statement purposes. It is unlikely this change will affect tax classification standards.208a


The NYSBA Reforms Report asks the Service to issue a revenue ruling that would confirm the tax treatment as debt of pass-through debt certificates issued by a credit card securitization trust. See the Attachment to this Supplement, paragraph 5.

202c For a general discussion of the issue raised by Castle Harbour, see Robert Scarborough,

“Partnerships as an Alternative to Secured Loans,” 58 Tax Lawyer 509 (Winter 2005). 208a See FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics

of both Liabilities and Equity (issued May 2003).

31

Chapter 4 Classification of Issuers Other Than REMICs and FASITs

A. Introduction


In Littriello v. United States, 2005-1 U.S.T.C. ¶50,385 (D.C. Ky. 2005), the court upheld the check-the-box regulations against a taxpayer challenge. The taxpayer was the sole member of an LLC that was treated as a disregarded entity under the regulations. He argued in vain that the regulations were invalid, with the result that the LLC should be treated as a corporation and he would not be individually liable for the LLC’s unpaid withholding and FICA taxes. The Littriello case was affirmed by the Sixth Circuit Court of Appeals on April 13, 2007 (484 F.3d 372). For an unavailing argument that the check-the-box regulations should be invalidated on appeal insofar as they impose employment taxes on the owner of a single member LLC, see Brant J. Hellwig and Gregg D. Polsky, “The Employment Tax Challenge to the Check-the-box Regulations,” 111 Tax Notes 1039 (May 29, 2006). Another case following Littriello is Sean P. McNamee v. Department of Treasury, 488 F.3d 100 (2d Cir. 2007).


The term “business entity” does not imply that the entity must engage in a trade or business. See Chapter 13, footnote 22.

B. Overview of Entity Classification Regulations

1. General

The proposed regulations relating to conversions of a foreign corporation into a disregarded entity in anticipation of a sale were withdrawn in November 2003 (see Announcement 2003-78, 2003-48 I.R.B. 1172). The IRS then promptly lost a case involving an extreme version of the facts addressed by the proposed regulations (a check-the-box election on the eve of sale to convert a stock sale into an asset sale to avoid adverse consequences under subpart F). See footnote 29a below (in this Supplement) and accompanying text.

Add the following new footnote 13a at the end of the parenthetical “(effectively a branch of its owner)” appearing in the second sentence of the carryover paragraph on pages 154 and 155:

See, e.g., P.L.R. 200522006 (March 4, 2005) (holding that a U.K. corporate taxpayer was considered the direct owner of shares held by two wholly-owned, disregarded entities of the taxpayer for purposes of Article 10(3)(a) of the U.S-U.K. income tax treaty (provision which eliminates source-country withholding tax on dividends received from directly-owned 80 percent (or greater) subsidiaries)).

2. Per se Corporations

Chapter 4

32

Add the following at the end of the bulleted list of per se corporations at the top of page 156:

• An entity with multiple charters (i.e., created or organized under the laws of more than one jurisdiction) if the entity would be treated as a per se corporation as a result of its formation in any one of the jurisdictions in which it is created or organized.17a

Replace the second and third sentence of footnote 16 with:

Treasury Regulation § 301.7701-2(b)(6) was amended, effective January 14, 2002, to provide that a business entity wholly owned by a foreign government (or by any entity described in Treasury Regulation § 1.892-2T) will be treated as a per se corporation. The cited regulation under section 892 refers to a controlled entity that is separate in form from a foreign sovereign or otherwise constitutes a separate juridical entity, if it is wholly owned and controlled by a foreign sovereign, directly or through other controlled entities, is organized under the laws of the controlling foreign sovereign, and credits its net income to its own account or to other accounts of the foreign sovereign, and its assets vest in the foreign sovereign upon dissolution. A controlled entity does not include entities owned and controlled by more than one foreign sovereign.


Public limited liability companies formed under the laws of the European Union (Societas Europaea), Estonia (Aktsiaselts), Latvia (Akciju Sabiedriba), Lithuania (Akcine Bendroves), Slovenia (Delniska Druzba) and Liechtenstein (Aktiengesellschaft) have recently been added to the list of per se corporations. See Notice 2004-68, 2004-43 I.R.B. 706 (October 25, 2004). Notice 2007-10, 2007-4 I.R.B. 354, adds the Bulgarian aktsionerno druzhestvo. A temporary regulation following up on this 2007 notice was adopted by T.D. 9388. Announcement 2008-38 (April 28, 2008) corrects the entry for Romania as “Societate pe Actiuni.”


Similarly, an eligible entity that makes a valid S corporation election is treated as also having made an election to be classified as an association (i.e., a corporation). The deemed election will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election under Treasury Regulation § 301.7701-3(c)(1)(i) to be classified as other than an association. See Treasury Regulation § 301.7701-3(c)(1)(v)(C) (effective for elections filed on or after July 20, 2004).

3. Default Rule and Mechanics of Election


17a Treasury Regulation § 301.7701-2(b)(9). These regulations were adopted as final regulations by

T.D. 9246 in January 2006 and replaced temporary regulations issued in August 2004. The final regulations generally apply as of August 12, 2004 to entities in existence on or after that date, but apply to entities created or organized under the laws of more than one jurisdiction as of August 12, 2004 only as of May 1, 2006, unless they choose to rely on the new rules as of August 12, 2004. By way of example, under these regulations, a Delaware limited liability company that is also chartered as a public limited company in the U.K. (a type of per se corporation under the check-the-box regulations) would be classified as a domestic corporation (domestic because of its status as a Delaware LLC and a corporation because of its status as an English plc).

Chapter 4

33

Treasury Regulation § 301.7701-5, a final regulation which replaces a temporary one adopted on August 11, 2004 by T.D. 9153, confirms this result.

Add the following new footnote 25a at the end of the first sentence following the reference to footnote 25:

The IRS has the authority under Treasury Regulation §§ 301.9100-1 and 301.9100-3 to grant an extension of time for the filing of an entity classification election. The Service will grant such an extension when the taxpayer provides satisfactory evidence that the taxpayer has acted reasonably and in good faith, and the grant of relief will not jeopardize the interests of the government. Ordinarily, an extension is obtained by filing a request for a private letter ruling which is subject to the normal procedures governing such requests. See, e.g., P.L.R. 200426012 (March 15, 2004) (foreign entity satisfied requirements of Treasury Regulation § 301.9100-1 and 301.9100-3 and was granted a 60-day extension to elect to change its federal tax classification). In Revenue Procedure 2002-59, 2002-39 I.R.B. 615, the Service provided a simplified method to request an extension for a classification election made for a newly-formed entity, provided the request is filed prior to the due date of the federal tax return for the entity (assuming its desired classification and excluding extensions) for the taxable year beginning with the date of the entity’s formation. The extension is not automatic but still requires that the entity have reasonable cause for its failure to timely make the election. The request for extension is made by filing Form 8832 (stating at the top “Filed Pursuant to Rev. Proc. 2002-59” and attaching a statement explaining the reason for the failure to file a timely election). Extension requests made after the deadline set out in the revenue procedure continue to be subject to the private letter ruling procedure. Revenue Procedure 2002-59 superseded Revenue Procedure 2002-15, 2002-1 C.B. 490, which was substantially the same except that it had different time limits for filing the request.


There is, apparently, no requirement that the entity have an intention to make an election at any time prior to actually making it. Thus, a taxpayer could base its decision whether to elect on factors not known at the time when the election would be effective (including the performance of the assets of the entity).


In P.L.R. 200426012 (March 15, 2004), the IRS granted permission to a foreign entity to elect to change its federal tax classification prior to the expiration of the 60-month no-change period following a change in ownership of more than 50 percent.

4. Effect of Elective Changes in Classification

Add the following new footnote 28a at the end of the first sentence:

Sometimes truth is no stranger than fiction. Revenue Ruling 2004-59, 2004-24 I.R.B. 1050, holds that the actual conversion of a state law partnership into a corporation under a state statute that does not require a transfer of the assets or liabilities of the partnership (a state law formless conversion statute) has the same consequences as a conversion effected through a check-the-box election.

Replace “Id.” at the end of footnote 29 with the following:

Chapter 4

34

The complete liquidation of an 80-percent owned subsidiary into a corporate parent is generally tax-free to the parent if the liquidation meets the requirements of section 332 (including certain timing requirements tied to the adoption of a plan of complete liquidation). The making of an election to classify a corporation as a partnership or disregarded entity is considered the adoption of a plan of complete liquidation immediately prior to the deemed liquidation triggered by the election. This rule applies to elections made on or after December 17, 2001, and to prior elections if the corporate owner claiming treatment under section 332 and its subsidiary making the election take consistent positions with respect to the federal tax consequences of the election. Id. In Revenue Ruling 2003-125, 2003-52 I.R.B. 1243, the Service held that a U.S. corporation that owned all of the stock of a foreign entity and made an election to reclassify the entity from a corporation to a disregarded entity was allowed a worthless security deduction under section 165(g)(3) if the fair market value of the assets of the entity, including intangible assets such as goodwill and going concern value, did not exceed the entity’s liabilities, so that on the deemed liquidation of the entity the U.S. parent received no payment on its stock.


In the first court case to address the consequences of a check-the-box election, the Tax Court held that a CFC that sold stock of a subsidiary at a gain could successfully avoid treating the gain as arising from a sale of stock (and therefore as subpart F income) by making a check-the-box election to liquidate the subsidiary on the eve of the sale.29a

It goes without saying that a check-the-box election is a tax election only, and therefore has

no effect on the status of legal claims against an entity. Thus, for example, a disregarded entity is considered separate from its owner for purposes of collecting pre-existing taxes of the entity with respect to a taxable period for which the entity was not disregarded.29b Similarly, the fact that a limited liability company is classified as a partnership for tax purposes does not imply that the IRS can collect employment taxes owed by the LLC from the members as if they were partners (the application of employment taxes to disregarded entities is discussed further below).29c The conversion of a corporation into an LLC treated as a disregarded entity owned by a second corporation does not alter the legal rights of creditors of the first corporation so as to cause a modification of debt.29d Finally, a loan secured by equity in a disregarded entity whose assets

29a Dover Corp. v. Comm’r, 122 T.C. 324 (2004). Subpart F is discussed in Chapter 13, Part G.5.

The holding in Dover and other check-the-box tax planning was threatened by a proposed expansion of section 269 in the Senate version of the bill that became the AJCA 2004, but the amendment was not included in the final bill. For a description of the amendment, see James M. Peaslee, “Dover Done in by Senate ETI Bill; Don’t Be the Last to Know,” 103 Tax Notes 1412 (June 14, 2004).

29b See Treasury Regulation § 301.7701-2(c)(2)(iii). A similar rule applies to entities that are disregarded as qualified REIT subsidiaries or qualified subchapter S subsidiaries. See Treasury Regulation §§ 1.856-9 and 1.1361-4(a)(6). All of these regulations were adopted on February 25, 2005, by T.D. 9183, effective April 1, 2004.

29c See Revenue Ruling 2004-41, 2004-18 I.R.B. 845. Similarly, a bankruptcy of owners of an LLC apparently classified as a partnership for income tax purposes did not permit the LLC itself to stay collection of employment taxes under the bankruptcy automatic stay on collections. People Place Auto Hand Carwash LLC v. Comm’r, 126 T.C. 359 (2006).

29d See P.L.R. 200315001 (September 16, 2002) described in Chapter 6, footnote 234 (in this Supplement).

Chapter 4

35

consist predominantly of real property may, but need not always, be regarded as a loan secured by real property for tax purposes.29e

A disregarded entity may be treated as separate from its owner for certain reporting and

procedural purposes. For example, a disregarded entity may be considered a “pass-thru partner” under the TEFRA partnership provisions and may be designated the tax matters partner.29f For a discussion of information reporting by foreign disregarded entities, see Chapter 14, Part H.5.

The Service has blown hot and cold on the application of employment taxes to a disregarded

entity. Notice 99-6, 1999-1 C.B. 321, provides that employment tax liabilities and other employment tax obligations with respect to employees performing services for a disregarded entity may be satisfied by having the calculation and payment be done by the owner under the owner’s name and employer identification number, or in the name and under the number of the entity. The notice states that in either case, the ultimate liability for employment taxes remains with the owner. Consistent with this notice, in 2005, the IRS successfully asserted in Litriello and other cases, that the owner of an LLC that is a disregarded entity is an employer subject to employment taxes relating to employees of the entity. See the discussion in Part A, above, in this Supplement. In that setting, courts rejected attempts by the taxpayer to invalidate the check-the-box regulations. On August 16, 2007, the Service issued final regulations that treat a disregarded entity as a separate entity for employment tax purposes (and also for purposes of certain excise taxes), and eliminate the liability for those taxes of the owner.29g However, the owner would continue to be treated as self-employed for purposes of SECA taxes and for other federal tax purposes. The regulations would be effective for periods beginning on or after January 1 following the date the regulations are adopted as final regulations. The employment tax provisions of these regulations apply to wages paid on or after January 1, 2009.

Sometimes taxpayers embrace corporate status only to find that it was a mistake. If the

mistake is corrected within one taxable year, it may be possible to have the tax equivalent of a Mulligan (a stroke that does not count). P.L.R. 200613027 involved an LLC that was taxed as a partnership. The LLC converted to a state law corporation in anticipation of an IPO. The markets tanked and the offering was cancelled. Wishing to avoid an unnecessary corporate tax, the parties reconverted the corporation to an LLC and obtained a ruling that the temporary conversion could be ignored, based on the tax law doctrine of rescission recognized in Revenue Ruling 80-85, 1980-1 C.B. 181. That ruling allowed a sale of real property subject to a zoning change to be ignored for tax purposes when the change did not come through and the sale was reversed within the same taxable year in which it occurred and all parties were placed in the same position as if the transaction had not occurred. The 2006 ruling recites certain facts to establish that no actions had been taken during the corporate period that were inconsistent with continuing status of the entity as a tax partnership.

It would be odd in policy terms if the same principle did not apply to a change in

classification that is made and then reversed under the check-the-box rules. One obvious practical issue is how to make the second election to reverse the first given the limitation on making a second change in status election for the same entity within five years. Presumably, the

29e See Revenue Ruling 2003-65 discussed in Chapter 11, Part B (in this Supplement). 29f Revenue Ruling 2004-88, 2004-32 I.R.B. 165. 29g See T.D. 9356, 2007-39 I.R.B. 675. The rule for disregarded entities is in Proposed Regulation §

301.7701-2(c)(2)(iv) and (v).

Chapter 4

36

taxpayer would take the view that it is not making a second election but rather revoking the first. The check-the-box regulations do not say that an election once made is irrevocable, although that is likely the case, at least as a general matter. 5. Number of Owners

Add the following new footnote 30a at the end of the third full paragraph on page 160:

See Revenue Ruling 2004-77, 2004-31 I.R.B. 119.

Add to the end of the first sentence of footnote 31: , each of which was declared obsolete by Revenue Ruling 2003-99, 2003-34 I.R.B. 388.

Add the following to the text immediately prior to the last sentence of the carryover paragraph on pages 162 and 163:

Finally, if feasible in light of the non-tax reasons for having a second member, the second member could be given no economic rights and no significant managerial rights.37a

C. Existence of an Entity

Add the following new heading at the beginning of Part C:

1. Overview

Add the following new footnote 47a at the end of the first full paragraph on page 166:

Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, below (in this Supplement), treats a Delaware statutory trust as an entity based on its treatment as a separate entity under state law (including limited liability).

Delete the last sentence of the second full paragraph on page 166, including footnote 49.

Add the following at the end of Part C:

2. Segregated Portfolio Companies

In recent years, a number of jurisdictions have enacted laws that allow legal entities to be divided into segregated portfolios (also referred to as series or protected cells) that can be segregated from each other legally in a way that resembles separate entities. Most importantly, assets of one portfolio can be protected against liabilities of other portfolios even if there is not a contractual term limiting liability. The entities may be trusts or companies. For reasons of 37a In P.L.R. 200201024 (October 5, 2001), the Service held that a nominal equity interest in a two

member LLC could be ignored (so that the LLC could be treated as a single member, disregarded entity of the holder of the other equity interest) where the nominal interest was created solely to create “bankruptcy remoteness” and provided for no economic interest (or significant management rights) in the LLC. See also P.L.R. 199911033 (December 18, 1998) (same). As an analogy, consider the rule discussed in Chapter 6, Part B.1.a.(v) allowing certain de minimis interests in REMICs to be disregarded.

Chapter 4

37

administrative convenience, segregated portfolio companies (SPCs) are being widely used in structured finance and securitization transactions. A number of articles have been written describing SPCs and, generally, arguing that each portfolio should be treated as a separate entity for tax purposes, at least where it is structured to have separate assets and liabilities.49a

At the beginning of 2008, the IRS issued Revenue Ruling 2008-8,49b Notice 2008-19,49c and

P.L.R. 200803004 (dated October 15, 2007), which support the view that SPCs should be treated as separate entities, at least in certain circumstances. They are summarized below.

a. Revenue Ruling 2008-8. Revenue Ruling 2008-8 holds that the activities of a particular “cell” (the term used to describe an individual portfolio) within an SPC determine whether risk-shifting arrangements between the cell and the owner of the cell or its affiliates will be treated as insurance contracts for federal tax purposes.

The ruling involves a legal entity (an SPC) formed by a sponsor under the laws of Jurisdiction A (it is not clear if this is a domestic or foreign jurisdiction, but it should not matter). The SPC has separate “cells,” each of which has its own name and is identified with a specific participant, but is not treated as a legal entity distinct from the SPC. Sponsor owns all of the common stock of the SPC. Each cell’s participant owns all of the non-voting preferred stock associated with the cell.

Each cell is funded by its participant’s capital contribution and by “premiums” the cell

collects on contracts. The assets and liabilities of each cell are accounted for separately, and the assets of each cell are protected statutorily from creditors of other cells and of the SPC. The SPC itself has the minimum amount of capital (held outside of the cells) necessary to maintain its charter. Each cell may make distributions on its own preferred stock (subject to meeting claims of its own creditors) regardless of whether distributions are made by other cells.

The ruling compares the activities of two cells, cell X and cell Y. Domestic corporation X

and domestic corporation Y own all of the preferred stock of cell X and cell Y, respectively. Cell X enters into an insurance arrangement only with X, protecting X against certain professional liability risks. Cell Y enters into insurance arrangements with 12 domestic subsidiaries of Y (presumably classified as corporations), protecting those subsidiaries against professional liability risks.

As explained in the ruling, in order for an arrangement to constitute insurance for federal

income tax purposes, both risk shifting and risk distribution must be present. Risk distribution requires some pooling of risks of different persons. Accordingly, an arrangement shifting risk from a parent to its wholly owned insurance subsidiary will not qualify as insurance unless the shifted risk is pooled by the subsidiary with risks from other parties (including affiliated

49a See, e.g., James M. Peaslee and Jorge G. Tenreiro, “Tax Classification of Segregated Portfolio

Companies,” 117 Tax Notes 43 (October 1, 2007); and Michael E. Mooney, “Series LLCs: The Loaves and Fishes of Subchapter K,” 116 Tax Notes 663 (August 20, 2007). The argument for separate treatment is based primarily on the authorities cited in footnote 141 below treating series funds organized as state law trusts as separate entities.

49b 2008-5 I.R.B. 340. 49c 2008-5 I.R.B. 366.

Chapter 4

38

corporations). An arrangement under which a subsidiary takes on risks from multiple sister subsidiaries of the same parent may qualify as insurance for federal income tax purposes.

The ruling holds that under the facts presented, the arrangements between each corporation

and the cell it owns should be considered equivalent to an arrangement with a wholly owned subsidiary. Accordingly, the arrangement between X-cell and X is not insurance (involves risks of one parent, no pooling) and the arrangement between Y-cell and Y is insurance (risks of 12 subsidiaries are pooled).

Although not stated in so many words, the central message of the ruling seems to be that

risks assumed by other cells within the same SPC are simply ignored in analyzing contracts with cell X or cell Y, because each cell is functionally a separate entity.

Although the ruling addresses the separateness of the cells only in the context of applying

the tax-law definition of insurance, the tax law classification of entities is directly relevant to that question. Thus, risk sharing among 12 subsidiaries of a parent corporation is considered insurance if the subsidiaries are classified as corporations for tax purposes but not if they are disregarded entities.49d

b. Notice 2008-19. Notice 2008-19 states that the IRS proposes to issue prospective guidance (which could take the form, among other possibilities, of a revenue ruling or regulation)49e to the effect that a segregated portfolio within an SPC (again referred to as a “cell”) would be treated as an insurance company separate from any other entity or cell if the cell is legally segregated from other cells49f and activities of the cell, if conducted by a separate corporation, would result in its being classified as an insurance company for federal tax purposes. An insurance company under federal tax standards is any company more than half of the business of which during the taxable year is the issuance of insurance or annuity contracts or the underwriting of risks underwritten by other insurance companies. An insurance company is automatically classified as a corporation under section 7701(a)(3).

According to the notice, the treatment of a cell as a separate insurance company would have

the usual consequences (e.g., separate elections, status as a member within a consolidated group of companies, activities of a cell not attributed to SPC in deciding if it is an insurance company). The notice indicates that no inference should be drawn regarding the treatment as a separate insurance company of a cell that does not meet the requirements set out in the notice.

The notice requests comments on a number of related topics, including whether different or

special rules should apply with respect to foreign entities, including controlled foreign corporations; and what guidance, if any, would be appropriate concerning similar segregated 49d Revenue Ruling 2005-40, 2005-2 C.B. 4. 49e The fact that a revenue ruling is listed as a possible means of guidance indicates that the IRS may

consider the treatment of each cell as a separate company to be the proper treatment under current law. The proposed guidance would be effective for the first taxable year beginning more than 12 months after the date the guidance is published in final form.

49f Specifically, legal separation would require that the assets and liabilities of the cell be segregated from the assets and liabilities of any other cell and from the assets and liabilities of the SPC such that no creditor of any other cell or of the SPC may look to the assets of the cell for the satisfaction of any liabilities, including insurance claims (except to the extent that any other cell or the SPC has a direct creditor claim against such cell).

Chapter 4

39

arrangements that do not involve insurance. The notice also asks for comments on transition issues, reporting, and tax consolidation rules.49g

The notice does not state whether the SPC is or is not a per se corporation. It addresses

entity classification only by treating a cell as a separate entity if it is functionally and legally separate and qualifies as an insurance company, so that it is, as a separate entity, a per se corporation.

c. P.L.R. 200803004. P.L.R. 200803004 addresses the entity classification of economically separate LLC portfolios that were organized as separate series of a single domestic LLC. The LLC was a successor to a trust that was also divided into series and was taxable as a series fund under section 851(g) (described above). Thus, the portfolios consisted of investment securities and the LLC was registered under the Investment Company Act of 1940. The ruling holds that the LLC portfolios may be taxed (1) as disregarded entities or partnerships if they do not elect to be associations and have one or multiple owners, respectively, or (2) as separate regulated investment companies if they elect to be associations. This outcome is possible only if the portfolios are considered separate business entities under the tax classification rules. Oddly enough, the private letter ruling does not include any discussion of the separate entity treatment of the LLC portfolios. It is possible that the IRS was influenced by the fact that the LLC portfolios would be treated as separate corporations under section 851(g) if they were classified as corporations.


Revenue Ruling 92-105 was distinguished in Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, below (in this Supplement), on the ground that, unlike the facts of the earlier ruling, the beneficiaries in the 2004 ruling were not liable for trust obligations and did not retain the right to manage and control the trust property. In concluding that neither the trust nor its trustee was an agent of the beneficiaries, the 2004 ruling also notes that there was no agency agreement and neither the trust nor its trustee had acted as an agent in dealings with third parties. Here the ruling has a “cf.” cite to Comm’r v. Bollinger, 485 U.S. 340 (1988), which held in favor of the taxpayer that a corporation was acting as agent for its shareholders with respect to a real property asset, title to which was held by the corporation, where the agency relationship was set forth in a written agreement at the time the asset was acquired, the corporation was functioning as agent and not principal with respect to the asset for all purposes, and the corporation was held out as the agent and not principal in all dealings with third parties relating to the asset.

In footnote 51, replace Announcement 84-63 with Announcement 84-62.

Add the following at the end of the carryover paragraph on pages 166 and 167:

The IRS has held that a bank that pools assets owned by multiple investors into a single account for purposes of custody and investment management, where the investors do not have joint ownership of the assets in the pool or survivorship rights, is not required to treat the pool account

49g For a comment on Notice 2008-19 that, among other things, proposes that the IRS adopt a safe-

harbor rule for recognizing the separate status of protected cell companies, see letter dated May 2, 2008 to Douglas H. Shulman and Eric Solomon from the New York State Bar Association, Tax Section, 2008 Tax Notes Today 88-17.

Chapter 4

40

as a joint account for withholding and information reporting purposes, but instead may determine its obligations separately for each investor.52a

Add the following new footnote 54a at the end of the carryover paragraph on pages 167 and 168:

One area where the existence of an entity or lack thereof is important is in applying the like-kind exchange rules in section 1031. A fractional interest in real property or other tangible property may be eligible for tax-free exchange treatment under this section, but “interests in a partnership” (other than one that has successfully elected out of subchapter K) or “certificates of trust or beneficial interests” are not. See sections 1031(a)(2)(D) and (E).

Revenue Procedure 2002-22, 2002-14 I.R.B. 733, specifies the conditions under which the IRS will issue a private letter ruling that an undivided fractional interest in rental real property will be treated as a co-ownership arrangement and not as an interest in a partnership (or other business entity) among the co-owners or between the co-owners and lessees. The revenue procedure supersedes a no-ruling policy adopted in 2000. The revenue procedure includes a discussion of earlier rulings and cases distinguishing a co-ownership arrangement from a partnership. Those authorities indicate that a co-ownership arrangement must be limited to maintaining and leasing property and not extend to other business activities. To obtain a ruling, a long list of requirements must be met, including the following: (1) the co-owners must own the property as tenants-in-common and not through a trust or other local-law entity, (2) the number of co-owners cannot exceed 35, (3) the co-ownership cannot hold itself out as a partnership or other entity (and, in general, the co-owners cannot have owned the same property through a predecessor corporation or partnership), (4) the co-owners must maintain (by unanimous consent) the right to approve the hiring of any manager, the sale of the property, the creation of any blanket lien, or the entering into of any lease or debt (other actions may be by majority vote), (5) with limited exceptions, each owner must have the right to transfer, partition, or encumber its undivided interest in the property without the need for approval by any person, (6) each co-owner must share in revenues, costs and indebtedness proportionately, (7) proceeds of sale must be distributed to co-owners after satisfying debts, (8) any call options on co-ownership interests must be for fair market value at the time of exercise, and put options must be to third parties that are not co-owners, lessees or lenders (or related to them), (9) the co-owners’ activities must be limited to those customarily preformed in connection with the maintenance and repair of rental real property, (10) management or brokerage agreements must be renewable at least annually and are subject to other restrictions, (11) leases must be on arm’s length terms and not provide for rents contingent on profits or income, (12) the lender with respect to any debt that encumbers the property or is used to acquire a co-ownership interest must not be related to any co-owner, the sponsor, the manager, or any lessee of the property, and (13) any payments to the sponsor must be on arm’s length terms and not depend on the income or profits derived from the property.

Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, below (in this Supplement), holds on the particular facts that a Delaware statutory trust was classified as a trust rather than as a business entity, and, therefore, the equity interests in the trust would be treated as interests in the underlying trust assets for purposes of applying section 1031.

For an article describing recent and ancient authorities distinguishing a partnership from a co-ownership arrangement, see Bradley T. Borden, Sandra Favelukes, and Todd E. Molz, “A

52a See P.L.R. 200450003 (July 2, 2004).

Chapter 4

41

History and Analysis of the Co-Ownership-Partnership Question,” 106 Tax Notes 1175 (March 7, 2005). See also Bradley T. Borden, “Revisiting the Federal Tax Definition of Partnership and the Section 71(a)(1) Election in the TIC Environment,” Tax Management Memorandum, February 6, 2006.

D. Status of Investment Trusts as Trusts or Business Entities

2. Family Trusts, Business Trusts, and Investment Trusts

b. Business Trusts


In P.L.R. 200517020 (December 20, 2004), the IRS held that a trust formed to hold investments in portfolio companies previously held by a liquidated venture capital fund and to make follow-on investments in equity or debt of the same portfolio companies was a business trust (and therefore not an investment trust) that was classified as a partnership. The trust’s activities seemed consistent with an investment trust having a power to vary investments, and, thus it appears the outcome would have been the same if the trust had been regarded as an investment trust. See Part D.4 in the text, below. The trust had the power to hold equity interests in entities classified as partnerships which may have influenced the classification. The fact that the investments may have been sizeable (allowing some participation in management) may also have been relevant.


Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, below (in this Supplement), holds on the particular facts that a Delaware statutory trust was classified as a trust, and not a business entity, for federal income tax purposes.

c. Investment Trusts Add to the end of footnote 68:

Revenue Ruling 2004-86, 2004-33 I.R.B. 191, supports the statement in the text that virtually any trust that holds investments and arises in a commercial setting ought to be considered an investment trust subject to Treasury Regulation § 301.7701-4(c)(1). The ruling considers the tax status of a Delaware statutory trust, which was established by an individual A to hold real property A had purchased using the proceeds of a nonrecourse loan and leased under a net lease. The ruling states that the trust interests were freely transferable (although not traded on an established securities market; it is not clear if they were certificated). A exchanged interests in the trust for real property held by B and C. The ruling considered whether, for purposes of applying the like-kind exchange rules in section 1031, the trust interests were properly viewed as interests in the underlying real property (which could qualify for like-kind exchange treatment) or as “certificates of trust or beneficial interests” (which could not qualify (see section 1031(a)(2)(E)). The ruling concludes that the trust was an entity, was not acting as an agent of the trust beneficial owners, and was an investment trust classified as a grantor trust (and not a business entity) because it met the requirements of the Sears regulations (no power to vary and a single class of ownership interests). Because the grantors of the trust were treated for tax purposes as owners of undivided fractional interests in the underlying trust property, like-kind exchange treatment was allowed. Notice 2008-34, 2008-12 I.R.B. 645, designates as a listed

Chapter 4

42

transaction a “distressed asset trust transaction” in which a tax-indifferent party contributes high basis, low value property to a trust, an unrelated U.S. taxpayer contributes assets to the same trust in exchange for certificates of beneficial interest in the trust, and the parties seek to allocate losses from the high basis assets to the U.S. taxpayer. For the transaction to work, the trust must be classified as a trust rather than a business entity. The IRS lists various possible grounds for disallowing the losses, including that the trust may not be a trust and that one or more of the entities in the transaction may properly be classified as a partnership. P.L.R. 200844002 (July 8, 2008), holds that a foreign pension plan was properly classified as a trust. Apparently, the entity was organized as a trust because the ruling states that it was governed by a “Board of Trustees”. The ruling does not discuss why the trust was not considered an investment trust with a power to vary or a business trust.

3. Trusts Holding Real Property Mortgages as Business Trusts

Add the following at the end of the third sentence in footnote 73 on page 175:

and Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, above (in this Supplement) (trust holding real property subject to a net lease and incurring nonrecourse debt classified as a trust).

4. Permitted Activities of Investment Trusts

d. Temporary Reinvestments

Add the following at the end of footnote 86 on page 181:

Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, above (in this Supplement), applies Revenue Ruling 75-192 to temporary investments without breaking any new ground.

Add to the end of footnote 87 on page 182:

In Revenue Procedure 2003-84, discussed in Chapter 5, Part C.8. (in this Supplement), a “temporary investment” pending distribution of the proceeds of disposition of tax-exempt bonds held by a partnership seeking to qualify for a simplified information reporting regime is limited to seven months.

e. Modifications of and Distributions on Trust Investments

The NYSBA Reforms Report proposes a change to Treasury Regulation § 301.7701-4(c) clarifying that a power to modify a real property mortgage held by a trust is not a power to vary, if the modification does not extend the term or increase the principal amount of the mortgage.

Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, above (in this Supplement), holds that a Delaware statutory trust holding real property that was leased to a tenant Z under a net lease and was subject to nonrecourse debt was classified as a trust. The ruling states that the trustee could not renegotiate the terms of the debt or the lease with Z or enter into leases with tenants other than Z, except in the case of Z’s bankruptcy or insolvency, and, unless otherwise require by law, could make only minor non-structural modifications to the real property.

Chapter 4

43

f. Partnership Interests and Loan Participations.


Chief Counsel Attorney Memorandum AM 2007-005 (February 5, 2007) characterizes as a partnership a fixed investment trust that issues pass-through interests and is formed solely to hold common interests in a limited liability company (LLC) that has the power to vary its investments and that itself was classified as a partnership for tax purposes. The LLC issues, in addition to the common interests, manager interests that are held by a select group of investors who are also responsible for managing the LLC. The Attorney Memorandum does not indicate what percentage of the LLC was owned by the trust. The Attorney Memorandum concludes that because the trust was formed to provide investors with the benefit of the managed investments of the LLC, the trust is classified as a business entity and not a trust. The Attorney Memorandum obviously did not assign much weight to the fact that the trust was not itself a manager, and indeed cites Comm’r v. Chase Nat’l Bank, 122 F.2d 540 (2d Cir. 1941), for the proposition that in determining the character of an arrangement, the managerial powers of all parties to the arrangement will be combined in order to arrive at the full amount of permitted managerial activity and its object. It would appear that the main consequence of the holding is that the trust, as a tax partnership, would be required to provide Schedule K-1s to investors. See Chapter 14 for a discussion of information reporting with respect to pass-through certificates issued by grantor trusts and partnerships. Revenue Ruling 2007-42, 2007-28 I.R.B. 44, provides that for purposes of applying the active trade or business tests in section 355(b), a corporation will be considered to be engaged in the active conduct of a trade or business if it owns a significant interest in a partnership (one-third or more). Revenue Ruling 92-17, 1992-1 C.B. 142, had concluded that a partner who owns a 20 percent interest and performs active and substantial management functions for the business of a partnership would be considered to be engaged in the active conduct of a business for purposes of the same section. Cf. Treasury Regulation § 1.368-1(d)(4)(iii) (in applying reorganization business continuity test, a corporation is considered to conduct the business of a partnership if it owns a significant interest in the partnership or has active and substantial management functions as a partner).

g. Inside Reserve Funds.


See also Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, above (in this Supplement), which holds that a Delaware statutory trust could hold a reserve fund (invested in short-term debt instruments that were held to maturity) to pay reasonable expenses associated with holding real property leased under a net lease and still be classified as a trust for federal income tax purposes.

i. Certificateholder Approval


Securities held by a grantor trust may by their terms allow holders to exercise voting rights. Suppose a trust agreement requires a trustee to exercise those rights proportionately according to directions received from certificate holders (i.e., a holder of x percent of the certificates could

Chapter 4

44

exercise x percent of voting rights). While there appear to be no authorities addressing the point, such a mechanism should not be considered to create a power to vary, even if a vote may involve a material change in terms. The passing through of voting rights to certificate holders allows the beneficial owners of trust assets to take actions they could take if they owned directly the underlying assets; it brings the assets closer to them and reduces the significance of the trust.114a It would seem very odd, then, to rely on the passing through of the vote as a basis for converting a trust into a business entity. More technically, it could be argued that the requirement of a power to vary investments “under the trust agreement” implies a delegation of power from the certificate holders to someone else. Another way to look at the issue is that the pass-through of the vote takes away from the status of the entity as a trust and makes it look more like a co-ownership arrangement.114b

j. Incurrence of Debt

Add the following new paragraph at the end of the section:

Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, above (in this Supplement), classifies as a trust a Delaware statutory trust that held real property that was leased to a tenant Z under a net lease and was subject to nonrecourse debt. The ruling states that the trustee could not renegotiate the terms of the debt. The nonrecourse debt was incurred by an individual A. A formed the trust on the date on which the debt was incurred and then contributed the property to the trust subject to the debt. The ruling puts to rest any question about the ability of an investment trust seeking trust classification to incur debt. The result should be the same if the trust incurs the debt directly in connection with its formation. The ruling also supports the view that a power to renegotiate the terms of debt may be treated as a power to vary investments.

k. Swaps and Other Derivatives


Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, above (in this Supplement), holds that a Delaware statutory trust holding real property that was leased to a tenant Z under a net lease and was subject to nonrecourse debt was classified as a trust. The ruling states that the trustee could not renegotiate the terms of the lease with Z or enter into leases with tenants other than Z, except in the case of Z’s bankruptcy or insolvency. The ruling provides some support for the view that a power to replace a swap upon a counterparty default is not a power to vary.

114a The text assumes that the terms of the underlying security allow the trust to cast votes according to

the directions of the certificate holders as if they were direct owners. The argument for treating the voting mechanism as a power to vary would be somewhat stronger if the trust were required to cast a single vote based on, for example, a majority vote of certificate holders because then the trust mechanism would be changing results compared with direct ownership (specifically allowing a majority to bind the minority).

114b For a discussion of the distinction between a trust and agency, see the text above at footnote 50. Under the four-factor test for classifying entities in existence before 1997, both trusts and associations were considered to have the common characteristic of centralized (i.e., delegated) management. For a discussion of this factor, see the second edition of this book, Chapter 3, Part C.2.a.(ii) and Revenue Ruling 64-220, 1964-2 C.B. 335 (trust engaged in a business and managed by beneficiaries classified as a partnership; it lacked centralized management).

Chapter 4

45

5. Multiple Ownership Classes

a. Overview


This proposal has been carried over by the Bush administration. See Part D.6.d, below (in this Supplement).

6. Further Applications of “Incidental” Exception

a. Synthetic Floating Rate Interests

Replace the sentence ending with the reference to footnote 152 and the next sentence with the following:

The “specified portion” rules in the REMIC regulations could serve as a model in defining permitted synthetic strips.152 In 2006, the IRS took that approach in a private letter ruling issued to Goldman, Sachs & Co., which holds that floating rate and inverse floating rate interests in a fixed rate mortgage (among other possible variable strips) qualified as stripped bonds under section 1286, with the result that a trust issuing those strip classes could be classified as a trust under the “incidental” exception.153 The ruling and its potential applications are described below. One of the authors represented the taxpayer in obtaining the ruling.

The ruling was issued to the taxpayer in its capacity as the future sponsor of a fixed investment trust. The ruling states that the sponsor will contribute to the trust assets consisting of all or a portion of a single class of mortgage pass-through certificates or of a single class of REMIC regular interests (“contributed assets”). The contributed assets (which the taxpayer represented to be debt for tax purposes) could pay interest at a fixed or variable rate (note, not just a fixed rate). In exchange for the contributed assets, the sponsor will receive multiple classes of separately assignable pass-through certificates. The certificates represent rights to different portions of the principal and interest payments on the underlying contributed assets (i.e., they will not be simply pro rata slices of the contributed assets).

The taxpayer represented that the trust will be a fixed investment trust with no power to vary the investment of certificate holders (so that it would be classified as a trust aside from any questions raised by the class structure of the certificates or the exchange features described below).

The certificate classes will pay interest at a fixed rate, floating rate or inverse floating rate. Interest payable on all of the classes will equal in the aggregate interest on the contributed assets

152 The specified portion rules are discussed in Chapter 7, Part C.4. Section 1286(f) grants the

Service unusually broad authority to issue regulations under the stripped bond rules. 153 See P.L.R. 200624005 (March 6, 2006). For an article discussing the ruling, see James M.

Peaslee, “Goldman Sachs Ruling on Variable Interests—An Epiphany at 1111,” 111 Tax Notes 1495 (June 26, 2006). For a more general discussion of the distinction between strips and other types of financial instruments, see George C. Howell III and Cameron N. Cosby, “Exotic Coupon Stripping: A Voyage to the Frontier Between Debt and Option,” 12 Virginia Tax Review 531 (1993).

Chapter 4

46

less trust expenses. Floating rate classes will have a pass-through rate that varies directly with an interest rate index (or a multiple of an interest rate index). Inverse floating rate classes will have a pass-through rate that varies inversely with an interest rate index (or a multiple of an interest rate index). Pass-through rates may be adjusted by adding or subtracting a fixed number of basis points and may be subject to caps or floors.

The principal amount of a class may be actual or notional. An actual principal amount represents a right to receive principal payments. A notional principal amount does not create a right to principal payments but is used in computing interest distributions.

A class of certificates may have a pass-through rate of zero. The ruling states as a fact that each class with a positive pass-through rate will be entitled to a share of the interest payable on the contributed assets that would constitute a specified portion of such interest payments if covered by the specified portion rules of Treasury Regulation § 1.860G-1.153a

The certificates are LEGO certificates with the usual exchange features.153b Thus there is flexibility to (1) add new contributed assets to the trust (identical to those already in the trust at the time of the contribution) in exchange for new certificates, (2) redeem certificates for contributed assets, or (3) exchange certificates of certain classes for certificates of classes with different terms representing in the aggregate economic interests in the same contributed assets.

Each exchange is for matching amounts (actual principal for the same amount of actual principal, and the same interest payments in the aggregate). The taxpayer represented that the exchanges will not be taxable events under section 1001 and that they involve no change in economic interests in underlying assets.153c The ruling states that the exchange feature permits exchanging certificate holders to take advantage of market opportunities that arise from differences in pricing of pro rata interests in the mortgages and separate pieces thereof.

153a The ruling also states that the specified portion will not vary over the life of the class “(i.e., until

payments are no longer made on the class, or the class is exchanged for contributed assets or a different class under the exchange feature of the Trust).” It is helpful that the ruling clarifies that the non-varying portion requirement of the specified portion rules is not violated as a result of the trust’s exchange features.

153b LEGO certificates are described in Chapter 2, Part B.5. 153c The conclusion that there is no taxable event is easy to reach. The exchanges do not alter the

economic interests in the contributed assets but rather change the way in which the same economic interests are allocated among different transferable classes. Thus an exchange can set the stage for future transfers of different partial interests in the contributed assets but in and of itself is an economic nothing. The exchange of a pro rata interest in a pool of mortgages for an economically equivalent direct interest in the mortgages (e.g., an exchange of a 10 percent interest in a pool consisting of mortgage A and mortgage B, each having a principal amount of $1,000, for a $100 principal amount of each of mortgage A and mortgage B) is not a taxable event. See, e.g., Revenue Ruling 90-7, 1990-1 C.B. 153, holding that the redemption of pass-through certificates issued by a fixed investment trust for a pro rata share of trust assets is not a realization event for the certificate holder. A description of Revenue Ruling 90-7 is included in the reasoning section of the ruling. Revenue Ruling 90-7, which reversed earlier authorities treating trust liquidations as a taxable event, is discussed in Chapter 5 at footnote 47.

Chapter 4

47

The ruling holds that the certificates qualify as “stripped coupons” or “stripped bonds” within the meaning of section 1286, 153d and that the trust will be classified as a fixed investment trust under Treasury Regulation § 301.7701-4(c).153e

The reasoning section of the ruling provides a straightforward description of section 1286 and the Sears regulations. Curiously, it does not explain the significance of the fact that interest payments on the certificates would represent a specified portion of the interest payments on the contributed assets under the REMIC rules if they applied.

While not certain based on the text of the ruling, the drafters may have been influenced by the following arguments in looking to the specified portion rules for guidance. First, under the “incidental” exception in the Sears regulations, whether trust interests should be taxed as direct co-ownership interests in the trust property rather than as equity in a business entity depends on whether the types of partial interests could exist as stand alone property items. The REMIC rules potentially allow interest payments on any mortgage to be divided into separately assignable specified portion classes. Thus, each fixed rate interest payment may be viewed as potentially comprised of any combination of variable rate interests that add up to the fixed rate and would be considered specified portion classes under the REMIC rules. Second, in more pragmatic terms, the fact that specified portion classes exist and are taxed as debt means that applying the stripping rule to treat similar instruments as newly issued stand alone debt is nothing new.

While the text of the ruling could be clearer, in applying the holding of the ruling in particular cases, the specified portion rules should be the touchstone for distinguishing good strips from bad (and not the language describing certificate classes as fixed rate, floating rate and inverse floating rate).153f

153d The ruling regarding the application of section 1286 is conditioned on the certificates representing

different portions of the interest and principal payments on the contributed assets (which the taxpayer had in any event represented to be the case). If the portions were the same, then there would be no separation of interest from principal and the stripping rules would not apply. By its terms, the ruling does not appear to address a case involving the carving up of rights to payments on debt instruments that, for tax purposes, do not have separately identifiable principal and interest payments (e.g., an IO class created as a stand alone class of REMIC regular interests under the specified portion rules). For a discussion of whether the stripping rules apply to zero coupon bonds, see New York State Bar Association, Tax Section, “Original Issue Discount and Coupon Stripping, Preliminary Report on Issues to be Addressed in Regulations and Corrective Legislation,” Tax Notes, March 5, 1984, 993, 1021 (Part III.D.1).

153e The ruling implicitly holds that the trust is not a TMP. This makes sense given that the trust is not used to create non-pro rata interests in rights to principal and thus does not have fast-pay, slow-pay features of the type that would invoke the TMP rules. See also Treasury Regulation § 301.7701(i)-1(g)(2) (an ownership interest in an entity classified as a trust under the Sears regulations will not be treated as a debt obligation of the trust for purposes of applying the TMP definition under an anti-abuse rule). The TMP definition is discussed in Part E, below.

153f For example, a certificate class that combines a fixed rate for one period with a floating rate for another period should be allowed because such a class can be created under the specified portion rules (in reliance on the fact that, under section 1.860G-1(a)(3)(vi), a variable rate includes a combination rate).

Chapter 4

48

Goldman, Sachs & Co. has sponsored two trusts under the Freddie Mac and Fannie Mae LEGO programs proving for variable strips.153g The ruling, however, draws no distinction between agency and private label programs, and should apply to both.

The facts of the ruling state that the trust will hold a single class of mortgage pass-through certificates or REMIC regular interests. Nonetheless, it should be possible to combine in a single trust multiple classes of pass-through certificates or regular interests as long as the tests in the ruling would have been met for each class of contributed assets and the classes of certificates that receive payments from that class of assets if they had been issued by a separate trust (or stating the point differently, the larger trust structure could have been created by simply aggregating, without a change in economic terms, smaller trusts that would meet the literal requirements of the ruling).

Although the focus of the discussion above has been on dividing up fixed rate interest payments into floating rate and inverse floating rate classes, the ruling also would accommodate a structure that allocates interest payments at a floating rate among multiple floating rate classes that float over different ranges. For example, a mortgage paying interest of LIBOR plus 250 basis points with a cap of 10 percent could be divided up into one class bearing interest at a rate of LIBOR plus 250 basis points with a cap of 7 percent and a second class bearing interest at a rate of LIBOR minus 450 with a cap of 3 percent.

The ruling should apply equally to commercial and residential mortgages. The references to mortgages in the ruling (and to REMIC regular interests) would include both.

Although the ruling is a private letter ruling issued to one taxpayer, it seems very likely that it will be widely accepted by tax advisors as changing the types of partial interests in mortgages that qualify under the stripping rules. The definition of stripped coupon is not very clear in the statute and can be read to accommodate at least some types of strips created using formulas. The REMIC specified portion rules provide a sensible, objective basis for identifying a permissible formula. The main reason why tax advisors have been unwilling to extend section 1286 to variable strips qualifying as specified portions of interest payments was the traditional hostility to an expanded reading of section 1286 expressed informally by the Service. The ruling signals that the IRS has gotten over the hump. Further, the IRS is not likely to change course again. The ruling was issued only after a thoughtful and careful review of the policy and technical issues by senior people in the Service.

The ruling by its terms applies to strips of real estate mortgages. The IRS could maintain that the rationale for the ruling is limited to mortgages, on the ground that the REMIC specified portion analogy does not extend beyond them. On the other hand, the taxpayer did not ask for guidance on strips of non-mortgage debt instruments, and there was no reason for the government to consider the larger question. By not explaining the significance of the specified portion rule in the discussion section of the ruling, the Service has left open the possibility that the reasoning will be applied in future guidance to any type of debt instrument (based on the view that the specified portion rules are relevant as a standard for identifying permitted types of interests rate based formulas). The issue may not be a pressing one, however, because the commercial desire to create variable rate strips subject to section 1286 seems to exist mostly in the mortgage area.

153g The offering circulars for the first Freddie Mac and Fannie Mae transactions are at

www.freddiemac.com/mbs.data.237om.pdf and www.efanniemae.com/syndicated/documents/mbs/remicsupp/2006-034.pdf.

Chapter 4

49

For more than a decade, trusts are been used to create floating rate and inverse floating rate interests in fixed rate municipal bonds. In the structure, a trust holds a fixed rate bond. It issues one class of ownership interests that is entitled to a share of interest income equal to a floating rate (set using a tax-exempt interest index or a remarketing mechanism) and a second class of ownership interests that is entitled to all remaining interest due on the bond. Such trusts are taxed as partnerships, on the basis that the stripped bond rules in section 1286 do not apply. The sponsors affirmatively want to avoid the stripping rules because of limitations found in the special rules for stripped tax-exempt bonds in section 1275(d).153h The IRS officials working on the Goldman Sachs ruling were well aware of the municipal bond precedents, and it is clear that the ruling was not intended to signal any change in the analysis of the tax-exempt bond trusts. They are clearly distinguishable from the trust in the ruling on the ground that they provide for a sharing in gain on sale that is not related to the way in which interest and principal payments are shared, 153i and may also be distinguishable based on the fact that the trust assets are not mortgages.

Add the following new section at the end of Part D.6:

d. Equity Strips. As the discussion above indicates, Example 4 in the Sears regulations confirms that a conventional bond stripping transaction (in which rights to interest on a debt instrument are separated from rights to principal) falls within the “incidental” exception. A trust or custody arrangement may also be used to separate rights to dividends on stock from other payment rights. Would the exception similarly apply?

The answer may be affected by future regulations. AJCA 2004 added a new section 1286(f) which authorizes regulations applying rules similar to section 1286 and section 305(e) (discussed below) to interests in accounts and entities substantially all of the assets of which consist of 153h See P.L.R. 200323015 (February 21, 2003), holding that a trust of the type described in the text is

properly classified as a partnership without considering possible application of the stripped bond rules (or the “incidental” exception). Historically, these trusts have elected out of the partnership rules in subchapter K (see Chapter 5, Part C.8), but the IRS has taken the position that this election cannot be made. At the end of 2003, the IRS adopted a new set of procedures for reporting income that is intended to take away some of the sting of partnership treatment without conceding the point that the election is proper. For a discussion of these procedures (principally Revenue Procedure 2003-84), see Chapter 5, Part C.8 (in this Supplement). Section 1286(d) limits the tax-exempt yield on a stripped bond or stripped coupon carved out of a tax-exempt bond to the lower of the original coupon rate of interest on the bond or the yield to maturity of the stripped interest based on its purchase price. It is not clear how the second part of the yield limitation would apply to variable rate interests, but it could possibly be read to cap tax-exempt interest on a variable rate stripped coupon or bond to interest computed based on the value of the variable rate at the time of purchase of the stripped coupon or bond. AJCA 2004 added a new section 1286(f) (discussed in Part D.6.d., below, in this Supplement), which authorizes regulations applying rules similar to section 1286 and the stripped preferred stock rules (in section 305(e)) to interests in entities or accounts substantially all of the assets of which consist of bonds, preferred stock, or a combination thereof. The legislative history states that this regulation authority is not intended to apply to certain transactions involving trusts holding tax-exempt bonds, such as the eligible tax-exempt bond partnerships described in Revenue Procedure 2003-84. See AJCA 2004 Conference Report, at 398. This legislative history indicates clearly that Congress did not intend for the stripping rules to apply to the traditional type of synthetic variable rate tax-exempt bonds.

153i Compare Example 3 in the Sears regulations (the Americus Trust example), which treats as a business entity a trust that holds publicly traded stock and issues one class of interests representing the right to appreciation of the stock above a specified amount and a residual class.

Chapter 4

50

bonds, preferred stock, or a combination of both. The section is effective for purchases and dispositions after October 22, 2004. The legislative history states that the regulations, when issued, would be applied prospectively except in cases to prevent abuse. See AJCA 2004 Conference Report, at p. 398. Regulations have not been issued under the new section. The 2008-2009 IRS Business Plan includes “[g]uidance under section 1286(f) as added by the American Jobs Creation Act of 2004 regarding treatment of stripped interests in bond and preferred stock funds” as a project the Service expects to complete in the plan year ending June 30, 2009. This item has been included in each of the business plans since the 2004-2005 IRS Business Plan. If and when regulations are adopted applying the principles of sections 1286 and 305(e) to equity strips, then Example 4 should apply directly. The discussion below analyzes the law before giving effect to any regulations that may be issued.

Absent regulations extending section 1286 to equity strips, the application of the Sears regulations to equity strips is not entirely clear, but there are strong arguments in favor of applying the incidental exception, particularly (but not exclusively) with respect to rights to dividends on preferred stocks. Example 3 in the Sears regulations holds that the exception does not apply to an arrangement for creating different ownership interests in stock where one ownership class has a right to appreciation of the stock above a specified amount and the other class has all other attributes of ownership. This example is readily distinguishable from the separation of rights to dividends from other rights, however, because a right to appreciation represents a right to a varying fraction of the stock that depends on its market value and cannot be identified with any particular payment or other right of ownership. By contrast, rights to dividends are readily identifiable. Also, they are often separated from other rights to stock in cases where stock is sold after the record date but before the payment date. Case law applying “assignment of income” principles address whether assignments of rights to future dividends are effective to shift the eventual dividend income from the owner of the stock to the assignee.158a These authorities assume that rights to dividends can be separated from other stock attributes through an assignment without the use of an intermediary.

One argument for distinguishing the stripping of interest off of debt instruments from the separation of dividend rights from stock is that there are explicit Code rules governing the tax treatment of stripped bonds and coupons. Accordingly, it is possible to compute income of holders of those items under a direct ownership approach.158b There is, however, an analogous provision for preferred stocks in section 305(e), enacted in 1993. Subsection (e) requires a purchaser of “stripped preferred stock” to include in income the excess of the redemption price of the stock over the purchase price as if such stripped preferred stock were an OID bond. The section also provides a special rule for the person stripping the stock. It does not address the holder of the dividend strip although it appears that a purchaser of the strip would be allowed to amortize the cost.158c While section 305(e) is not as complete as section 1286 in that it addresses

158a See, e.g., Stranahan v. Comm’r, 472 F.2d 867 (6th Cir. 1973); Bettendorf v. Comm’r, 49 F.2d 173

(8th Cir. 1931); Heminway v. Comm’r, 44 T.C. 96 (1965). 158b See footnotes 129 and 140, above, and accompanying text. 158c The legislative history of section 305(e) avoids giving substantive guidance on the tax treatment of

dividend strips. It states that “[n]o inference is intended as to the treatment of stripped preferred stock for tax purposes with respect to any issues not directly addressed by this legislation, including the availability of the dividends received deduction to a holder of dividends stripped from preferred stock, the allocation of basis by the creator of stripped preferred stock, or the proper characterization of a purported sale of stripped dividend rights.” House Rep. No. 103-111, 103d Cong., 1st Sess. 641 (reprinted in 1993-3 C.B. 163, 212). While the legislative history is

Chapter 4

51

only certain stocks and only the stripped principal component, it obviously assumes that it is possible to create direct ownership interests in rights to dividends and other payment rights in respect of corporate stocks. Further, because preferred stocks are not issued with dividend coupons or other mechanisms allowing separate registration of rights to dividends and other payments, Congress must have assumed that it was possible for holders to separate dividends from other payment rights using some kind of custody or participation arrangement without creating a tax partnership. (If there were a partnership, the partnership would own all interests in the stock and no stripped preferred stock would be created.) The section was enacted long after issuance of the Sears regulations.

A 2001 F.S.A. analyzes an equity stripping transaction and concludes that the arrangement creates a partnership.158d A corporation owning shares in a money market fund (a corporation for tax purposes) used a custody arrangement to separate rights to dividends for a fixed term from all residual rights in the shares. The corporation’s goal was to generate a loss by allocating all basis in the shares to the residual rights and selling those rights at a discount (reflecting the separation of dividend rights). Presumably, the fund was taxed as a RIC and was managed to maintain a constant redemption price.

Not surprisingly, the F.S.A. evinces hostility to the taxpayer’s ends and discusses various grounds for disallowing the loss. One is based on the view that the custody arrangement is properly viewed as a partnership. In that connection, the advice considers how the arrangement would be analyzed under the Sears regulations (if it were an investment trust).158e The advice concludes that the arrangement involves multiple ownership classes (no surprise there) and that those classes do not fall within the “incidental” exception. This second conclusion is reached without any real discussion apart from a statement that the multiple classes allow investors to fulfill their varying investment objectives of seeking primarily either dividend income or capital appreciation from the shares. The statement about capital appreciation seems off the mark given that the underlying shares are in a money market fund. The only capital appreciation would result from discounting the stock to reflect the separation of dividend rights. At any rate, the fact that there are material differences between the classes does not address whether rights to dividends and other payment rights can properly be viewed as distinct property rights. The buyers of short-dated and long-dated coupons in a bond stripping transaction would seem to have varying investment objectives to about the same degree as in the facts of the advice and yet bond stripping can be accomplished without creating a tax partnership.158f

thus not helpful in spelling out the treatment of the holder of the dividend strip, a special rule for dividend strips in section 167 implies that their basis may be recoverable through depreciation or amortization. Section 167(e)(1) provides that no depreciation or amortization deductions are allowed with respect to certain term interests in property where the remainder interest is held by a related party; however, section 167(e)(2)(B) provides an exception to this rule for “the holder of the dividend rights which were separated from any stripped preferred stock to which section 305(e)(1) applies.” The rationale may have been that it is unfair to require the accrual of discount for stripped preferred stock without allowing an amortization deduction in respect of the associated dividend rights.

158d F.S.A. 200146025 (August 2, 2001). 158e Custody arrangements may be regarded as trusts subject to the Sears regulations. See Chapter 4,

footnotes 62, 63, and 123. 158f A conclusion that there is no partnership would not necessarily mean a taxpayer victory. A

number of other grounds of attack are set out in the advice which are not evaluated here.

Chapter 4

52

A recent T.A.M. also analyzes an equity stripping transaction and similarly concludes that the arrangement creates a partnership.158g A corporation deposited perpetual notes that were treated as preferred stock for tax purposes into a trust in return for two certificates, one an IO certificate, which was entitled to all of the interest (dividends) on the note for a fixed term, and the other the residual certificate, which was entitled to all principal on the note if paid and all interest (dividends) on the note after expiration of the term of the IO certificate. Under a separately documented “Termination Agreement,” an affiliate of the holder of the residual certificate agreed to pay the holder of the IO certificate a portion of any principal payment the holder of the residual certificate received in the event that the note prepaid or defaulted during the term of the transaction. The taxpayer indicated that it considered the occurrence of the events triggering payments under the Termination Agreement to be “remote contingencies,” but on the other hand, that the parties would not have entered into the transaction on the same terms without the Termination Agreement. As in the F.S.A., the corporation’s goal was to generate a loss by allocating all basis in the note to the residual certificate and selling the residual certificate at a discount, reflecting the separation of the interest (dividend) rights.

Like the F.S.A., the T.A.M. evinces hostility to the taxpayer’s ends and concludes that the expected loss was not generated. It treats the trust arrangement and the Termination Agreement as part of a single integrated transaction and, after doing so, concludes that the trust was a partnership. Again like the F.S.A., the T.A.M. concludes that the two classes of certificates did not fall within the “incidental” exception. The reasons given for this conclusion are that “[t]he Certificates effectively separate current income rights on the Underlying Instruments from a portion of the right to appreciation on the value of the Underlying Instruments, similar to the circumstance described in Example 3 of section 301.7701-4(c)(2). In addition, the Termination Agreement provides Taxpayer protection from the risk that an Underlying Instrument will be prepaid. This type of protection is similar to that described as ‘call protection’ in Example 1 of section 301.7701-4(c)(2).” Some factors that could have distinguished the arrangement from these examples are that the likelihood of a payment under the Termination Agreement was considered remote, the Termination Agreement was in fact economically incidental to the arrangement rather than at its core, and the Termination Agreement did not require any ongoing adjustment during the term of the trust of allocations of income or payments. Also, it would have been possible to account for the Termination Agreement as a cash-settled put between the parties.

7. Definition of Ownership Interest


A guarantor of a pool of loans may receive a fee payable out of interest payments on the loans. In a case where the guarantor has no prior ownership interest in the loans and no economic interest in the transaction aside from the guarantee, the fee would necessarily represent arm’s length consideration for the guarantee and accordingly should not be recharacterized as an ownership interest in the loans.165a

158g T.A.M. 200650017 (August 18, 2006) (correcting some inaccurate language in, and replacing,

T.A.M. 200512020 (August 20, 2004)). 165a See Chief Counsel Notice CC-2002-016 (January 24, 2002), in which the IRS took this position in

providing guidance to staff lawyers on whether to apply the bond stripping rules of section 1286 to guarantee fees. The notice confirmed the traditional view outlined above (see footnote 162 and accompanying text) that excess servicing fees (i.e., fees exceeding reasonable compensation for services) paid to a seller/sponsor who previously owned loans may represent a retained ownership

Chapter 4

53

E. Taxable Mortgage Pools


The NYSBA Reforms Report proposes changes in the TMP rules that would limit the definition of real estate mortgage to assets that can be held by a REMIC, clarify that revolving pool debt issuers are not TMPs, and create an exception for entities that issue only short-term debt.

2. Definition of TMP

c. Relationship Test

(iii) Required relationship


Treasury Regulation § 1.704-1(b)(5), Example 8(ii), uses the phrase “in large part” but in a way that does not shed any light on its meaning.

g. Anti-Avoidance Rule

Add the following after the first full paragraph on 242:

A fact pattern that sometimes arises in practice and resembles one of the examples in the regulations is worthy of special mention. It relates to the use of equity interests in a trust issuer of NIMS to support additional debt classes. As described in Chapter 2, Part C (in this Supplement), NIMS are pay-through bonds that are supported by rights to net interest payments derived from high-yield mortgages. They are issued in a single class (or in two or more classes providing for pro rata payments of principal) to avoid qualification of the issuer as a TMP. If the holder of the trust equity were to use it standing alone to support a second class of debt, and the second financing was contemplated when the NIMS were issued, then the transaction pattern would resemble Example 1 in the regulations and there would a significant risk that the NIMS issuer would be classified as a TMP.238a By contrast, the anti-avoidance rule should not apply in a case where equity interests in a NIMS issuer are combined with other assets in a new securitization that involves sufficient diversification so that the identity of individual assets in the pool becomes lost and the debt issued in the new securitization is qualitatively different from any of the NIMS classes. The transaction pattern would then be distinguishable from Example 1 in that the NIMS would be supported only by the particular assets of the NIMS issuer, whereas the debt issued in the second securitization would be supported by a much larger pool of assets. It would also be helpful in avoiding the anti-abuse rule to be able to show that the second step securitization was not intended when the NIMS were issued, or at least could not have been effected without a significant delay because the NIMS were issued in the largest amount that could be supported at that time by the underlying cash flows. In Example 1, the first trust was only 50 percent

interest in the loans. The view that a right to guarantee fees can never be a stripped coupon assumes that the fee is earned over time. If a guarantee fee is fully earned when the guarantee is issued and is normally payable in a lump sum, conceptually, it would seem possible for the fee to be paid through delivery of a right to mortgage interest that would be a stripped coupon.

238a Example 1 is described in footnote 237, above, clause (1).

Chapter 4

54

leveraged and the second trust issued debt six weeks later with the same principal amount as the first.238b

F. Publicly Traded Partnerships

3. Passive Income Exemption

a. Qualifying Income—General Definition

Normally, whether income is qualifying income is not a topic of contentious debate. However, one aspect of this question that has become controversial is whether shares of profits received by partnerships in consideration for performing management services for investment partnerships, which are normally taxed as a share of investment income, should be treated as qualifying income. Taking the income out of the qualifying income definition would require a statutory change. For an article discussing the topic, see Robert Willens, “How Can an Asset Manger Qualify as a PTP?,” 116 Tax Notes 295 (July 23, 2007).


P.L.R. 200722007 (February 26, 2007) treated a partnership deriving a share of subpart F income from a CFC as receiving passive income, on the ground that such income was “other income” derived from its business of investing in the stock, within the meaning of section 851(b). Section 851(b)(3) has an explicit rule treating amounts included in income under section 951(a)(1) (subpart F) or 1293(a) (QEF election for PFIC) as good income to the extent distributed. The private letter ruling dealt with a case in which included amounts were not distributed currently. See also P.L.R. 200743005 (July 20, 2007) (ruling that income derived by a RIC with respect to stocks in series funds that are CFCs or PFICs constitutes qualifying income). For an article discussing the topic, see Dale S. Collinson, “Qualifying Income of a RIC From Investment in a CFC,” 114 Tax Notes 673 (February 13, 2007).

b. Interest from a Financial Business

The NYSBA Reforms Report recommends issuance of a revenue ruling holding that a traditional credit card securitization trust is not engaged in a financial business for purposes of section 7704. See Attachment, paragraph 3.

(i) Traditional definitions of a financial business.

Add the following at the end of the first full paragraph on 261:

Trading activity may also have to be regular and continuous (over a period of more than one year) to constitute a trade or business, at least if it is an incidental activity.296a

238b Example 1 does not say explicitly that the second debt issuance was contemplated when the first

was undertaken. Indeed, the example states that the second step was undertaken with a view to avoiding the TMP rules. However, given the timing (first step May 15, 1997, second step July 5, 1997) and the small amount of debt issued in the first step, it is highly likely that the requisite “view” existed at the time of the first step. It does not seem appropriate to apply the TMP anti-avoidance rule to aggregate steps unless they are all undertaken pursuant to an avoidance plan.

Chapter 4

55


The Fannie Mae victory has inspired Freddie Mac to take a similar position. In a Tax Court petition filed October 19, 2005 (Docket No. 19573-05), Freddie Mac objects to a proposed deficiency arising from capital treatment of losses arising from sales of participation certificates to dealers through mortgage dollar rolls (intended to assist dealers in assembling mortgages for REMICs) on the ground that the participation certificates are ordinary assets under the reasoning of the Fannie Mae case. Subsequently, in T.A.M. 200651033 (August 31, 2006), the Service reaffirmed its position that mortgage backed securities acquired in mortgage dollar roll transactions are not acquired in the ordinary course of a trade or business for services rendered within the meaning of section 1221(a)(4). (This part of the T.A.M. was later withdrawn as described below.) The T.A.M. also considered whether a settlement agreement between the taxpayer and the Service to treat the securities as ordinary assets with respect to certain years bound the Service to such treatment in years not covered by the agreement. The T.A.M. concluded that it did not.

Presumably with a view to cutting off similar arguments in the future, on August 7, 2006, the IRS issued Proposed Regulation § 1.1221-1(e), which would have prevented a loan of money from qualifying as an ordinary asset under section 1221(a)(4) on the ground that it represents a receivable acquired for the service of making funds available to the borrower or to market participants. The proposed regulation would have had the effect of denying ordinary treatment of loan gains and losses to loan originators or traders unless they were (1) banks benefiting from section 582(c) (described in Chapter 11, Part E) or (2) securities dealers or electing traders subject to section 475 and the loans have not been identified as held for investment or otherwise as falling outside of section 475. The proposal prompted an outcry from the affected parties and in May 2008, the IRS withdrew the proposed regulations in Announcement 2008-41, 2008-19 I.R.B. 943. The Announcement includes the following: “The IRS will not challenge return reporting positions of taxpayers under section 1221(a)(4) that apply existing law, including Burbank Liquidating; Federal National Mortgage Association; and Bieldfeldt v. Commissioner, 231 F.3d 1035 (7th Cir. 2000), cert. denied, 534 U.S. 813 (2001). See also Rev. Rul. 80-56, 1980-1 C.B. 154, and Rev. Rul. 80-57, 1980-1 C.B. 157. The IRS and the Treasury Department will continue to study this area and may issue guidance in the future.” Section 475 is discussed in Chapter 11, Part F.

Following the withdrawal of the proposed regulations, the IRS in T.A.M. 200839033 (June 12, 2008) withdrew the part of T.A.M. 200651033 (described above) dealing with section 1221(a)(4) in order to place the taxpayer on an equal footing with other taxpayers that may rely on the withdrawal of the proposed regulations.

Add the following to the end of footnote 315:

For a case that may be helpful in concluding that a person acquiring a loan, including one with ongoing funding obligations, from someone other than the obligor, is not engaged in a business 296a Frank Chen v. Comm’r, T.C. Memo 2004-132, 2004 Tax Notes Today 106-7 (June 1, 2004), held

that an individual who engaged in 323 securities transactions mostly over a two-month period, with little activity before and after, and who had a full-time job as a computer chip engineer, was not a securities trader (eligible to elect ordinary treatment under section 475(f)), on the ground that the activity was not frequent, regular and continuous. For a good article discussing the case, see Burgess J.W. Raby and William L. Raby, “Effect of ‘Sporadic’ Trading on Securities Trading Status,” 2004 Tax Notes Today 112-12 (June 9, 2004).

Chapter 4

56

since the customer relationship with the borrower is the originator’s, not the acquirer’s, see Marrin v. Comm’r, T.C.M. 1997-24, aff’d, 147 F.3d 147 (1998) (taxpayer that acquired and disposed of securities to earn a bid/ask spread was not a dealer when he did not hold himself out as a dealer and made all of his trades through a dealer; the court rejected the argument that the dealer’s customers should be attributed to the taxpayer).

57

Chapter 5 Taxation of Trusts (Other Than REMICs or FASITs) Issuing Pass-Through Certificates

B. Grantor Trusts

2. Application of Grantor Trust Rules to Investment Trusts

Reverse the text of footnotes 9 and 11 (to err is human).

Add to citation of Sumitomo Trust and Banking Co. (USA) in footnote 31: aff’d, 720 N.Y.S. 2d 251 (New York Supreme Court, Appellate Division, Third Department 2001).

Add the following to footnote 17:

Revenue Ruling 2007-13, 2007-11 I.R.B. 684, treats the grantor of an insurance trust as the owner of the underlying insurance policy for purposes of determining how transfers of the policy are treated under section 101(a)(2).

Add the following after “Act” in line 13 of footnote 31:

Similarly, Revenue Procedure 2004-28, 2004-22 I.R.B. 984, allows a RIC to treat a repo that is collateralized fully with Government securities as a Government security for purposes of the RIC diversification test in section 851(b)(3) despite the status of the repo as a secured loan for tax purposes, based on an SEC rule adopted under the diversification provisions of the 1940 Act that allows look-through treatment for fully-collateralized repos.


In Revenue Procedure 2003-32, 2003-1 C.B. 803, the IRS held that a synthetic variable rate tax-exempt bond taking the form of an interest in a trust holding tax-exempt bonds that is classified as a partnership for tax purposes (as described in Revenue Procedure 2002-68, 2002-2 C.B. 753, the predecessor of Revenue Ruling 2003-84) is treated as an interest in the underlying tax-exempt bonds for purposes of various RIC asset tests. The revenue procedure was necessitated by the decision of the IRS to not allow such trusts to elect out of subchapter K under section 761. See Chapter 5, Part C.8 (in this Supplement). Revenue Procedure 2003-32 was amplified and superseded by Revenue Procedure 2005-20, 2005-18 I.R.B. 990, to take account of the fact that Revenue Procedure 2002-68 was modified and superseded by Revenue Procedure 2003-84.

Add the following to the text after the reference to footnote 41:

Chapter 5

58

In a recent case, a grantor trust was treated as a separate entity for purposes of applying certain rules governing the taxation of shareholders of a CFC.41a


The 2008-2009 IRS Business Plan lists “[p]roposed regulations under section 751(b) regarding unrealized receivables and substantially appreciated inventory items of a partnership” as a project the Service expects to complete in the plan year ending June 30, 2009. The 2007-2008 and 2006-2007 IRS Business Plans also had included a similar item. The 2005-2006 and 2004-2005 IRS Business Plans had included a more general “[u]pdate of the section 751 regulations.” Notice 2006-14, 2006-8 I.R.B. 498, had previously announced that the Service was conducting a study of the section 751(b) regulations and considering alternative approaches.

3. Senior/Subordinated Pass-Through Certificates


F.S.A. 200147033 (August 14, 2001) takes the position that guarantee fees received by a foreign parent corporation for guaranteeing debt of U.S. subsidiaries, while not interest, should be considered analogous to interest (and not a payment for services) for purposes of determining the source of the fees. The interest analogy would be useful in arguing that such income is similar to other types of passive investment income when received by a party not engaged in an active business of providing guarantees. The specific holding regarding source would not be helpful to

41a Textron, Inc. v. Comm’r, 117 T.C. 67 (2001). The controlled foreign corporation (CFC) rules are

summarized in Part G.5 of Chapter 13. They generally attribute to a United States shareholder of a CFC certain subpart F income of the CFC, whether or not distributed. A United States shareholder is defined as a U.S. person owning at least 10 percent of the voting power of all voting stock of the CFC. The issue addressed in the case was whether Textron, a domestic corporation, was a United States shareholder of a CFC, Avdel, because of Textron’s beneficial ownership of Avdel stock through a domestic voting trust that was taxable as a grantor trust. The voting trust was established under a court order to prevent Textron from controlling Avdel pending resolution of an anti-trust challenge. Textron apparently argued that the test should be applied at the Textron level, ignoring the trust because it was a grantor trust, and that Textron was not a United States shareholder because it could not vote the Avdel stock. The court held that the relevant ownership tests did not contemplate looking through domestic intermediaries, and that the trust was the relevant shareholder. Because the trustee of the trust could vote the stock, the trust was a United States shareholder and was required to include in its income the subpart F income of Avdel. The income of the trust was in turn taxable to Textron under the grantor trust rules.

Textron, if taken to its logical extreme could have troubling results. Consider, for example, a single-class investment trust with respect to which no holder owns 10 percent or more of the equity. Suppose that the trust holds more than 50 percent of the voting equity of a foreign corporation but none of the corporation’s other equity is held by a “United States shareholder.” Under Textron, the foreign corporation would be a CFC and each holder of an equity interest in the trust would be required to include in income its pro rata share of the CFC’s subpart F income, notwithstanding that the corporation would not be a CFC (and no holder of trust equity would be a United States shareholder) if the stock were held directly by the equity holders in the trust. The Textron court could potentially have reached the same ultimate result more simply (and without creating an unfavorable precedent for grantor trusts generally) merely by holding that a person who is treated for tax purposes as owning voting stock through a trust classified as a grantor trust will not be treated as failing to have the voting power of the stock because the power is exercisable solely by the trustee or a third party acting for the trust.

Chapter 5

59

a foreign investor receiving guarantee fees relating to obligations of U.S. resident borrowers because, as discussed in Chapter 12, the U.S. withholding tax applies to income from U.S. sources. Proposed transfer pricing regulations relating to controlled services transactions define the term broadly enough to cover guarantee fees and other types of income from risk shifting not traditionally regarded as services income. See Proposed Regulation § 1.482-9(l).

C. Trusts Taxed as Partnerships

1. General Approach of Subchapter K



2. Inside and Outside Basis


AJCA 2004 amends section 704(c), generally effective for contributions after October 22, 2004, to provide that a built-in loss may be taken into account only by the contributing partner and not by other partners. Except as provided in regulations, in determining the amount of items allocated to partners other than the contributing partner, the basis of the contributed property is treated as the fair market value at the time of contribution. Thus, if the contributing partner’s partnership interest is transferred or liquidated, the partnership’s adjusted basis in the property is based on its fair market value at the time of contribution, and the built-in loss is eliminated.


Sections 743 and 734 were amended by AJCA 2004 to make basis adjustments thereunder mandatory, in the case of section 743, if the partnership has a substantial built-in loss immediately after the transfer of the partnership interest (generally, if the partnership’s adjusted basis in partnership property exceeds the fair market value of the property by more than $250,000), and in the case of section 734, if there is a substantial basis reduction (generally, if a downward adjustment of more than $250,000 would be made to the basis of partnership assets if a section 754 election were in effect at the time of the distribution), generally effective for transfers and distributions, respectively, after October 22, 2004. However, under sections 743(f) and 734(e), a “securitization partnership” is not treated as having a substantial built-in loss or a substantial basis reduction, respectively, with respect to any transfer or distribution of property to a partner, respectively. The definition of securitization partnership should cover traditional securitization vehicles holding fixed or revolving pools of receivables that are not trading vehicles. For the definition, see the Glossary (in this Supplement). In the case of section 743 only, there is also an exception for “electing investment partnerships.” However, in lieu of the partnership basis adjustments, a partner-level loss limitation rule applies which generally limits the losses allowed to a transferee partner from the sale or exchange of partnership property to losses exceeding losses already recognized by the transferor partner on its transfer of the

Chapter 5

60

partnership interest. The IRS provided interim guidance on implementing the AJCA 2004 partnership changes in Notice 2005-32, 2005-16 I.R.B. 895.

6. Disposition of Interests



7. Taxation of Pass-Through Debt Certificates as Partnership Interests

a. Foreign Investors

Regarding the text at footnote 115, the NYSBA Reforms Report recommends the issuance of a revenue ruling holding that a conventional credit card securitization trust is not engaged in a U.S. trade or business, relying on the securities trading safe harbor discussed in Chapter 13, Part D.2. See Attachment, paragraph 4.

The text at footnote 120 discusses a problem that arises in applying the portfolio interest exemption to partnership income allocated to foreign partners consisting of interest earned on consumer receivables that are not in registered form. The NYSBA Reforms Report proposes that the requirement of the portfolio interest exemption that interest be paid on an obligation in registered form be considered to be met if the interest is allocated to a partnership interest that is in registered form and the partnership consists of a pool of debt instruments and related assets.

The text on page 316 discusses how guaranteed payments are treated under the portfolio interest exemption. The NYSBA Reforms Report requests a clarification that guaranteed payments paid by a securitization vehicle be treated (1) as a distributive share of the partnership’s ordinary income and have the character of that income (typically, interest income) to the extent the guaranteed payment is deductible from the partnership’s ordinary income allocable to other partners and (2) otherwise, as interest paid by the partnership. In no event would it be treated as a third type of ordinary income (one not qualifying for an exemption from withholding). The withholding tax regulations provide some support for the treatment of guaranteed payments as a distributive share of income, at least to the extent they are paid out of income. Treasury Regulation § 1.1441-5(b)(2) imposes on a domestic partnership liability to withhold taxes “when any distributions that include amounts subject to withholding (including guaranteed payments made by a U.S. partnership) are made.”


On May 13, 2005, the IRS issued final and temporary regulations under section 1446, applicable to partnership taxable years beginning after May 18, 2005 (subject to an election to apply them to partnership taxable years beginning after December 31, 2004). The regulations supersede the revenue procedures cited above with respect to partnership taxable years to which the regulations apply. The regulations tailor the amount required to be withheld more directly to the amount due,

Chapter 5

61

and thus allow a partnership, when presented with appropriate certifications from partners, to take account of differences in the rates applicable to ordinary income and long-term capital gains for individuals and, for some partners, offsetting losses or credits that would reduce their ultimate tax liability. The regulations include special rules for publicly traded partnerships (as defined in section 7704, but limited to those that are not classified as corporations—for a description of section 7704, see Chapter 4, Part F). These rules require withholding on distributions made to foreign partners and on distributions by nominees holding partnership interests on behalf of foreign partners if a qualified notice has been given as to the amount subject to withholding.

On April 29, 2008, the IRS issued final regulations (T.D. 9394, reprinted at 2008-21 I.R.B. 988), generally applicable for partnership tax years beginning after December 31, 2007, addressing a foreign partner’s certification of deductions and losses to a partnership for purposes of calculating the partner’s allocable share of effectively connected income from the partnership and tax that the partnership must withhold on that income under section 1446. See generally, Treasury Regulation § 1.1446-6. The regulations contain a de minimis withholding exception for certain nonresident alien individual partners. Treasury Regulation § 1.1446-6(c)(1)(ii). Under the de minimis rule, a nonresident alien individual partner may certify to a partnership that his or her investment in the partnership constitutes the only activity that gives rise to effectively connected income, gain, deduction or loss. If so, and if the section 1446 withholding tax due for that partner would be less than $1,000 (before taking into account deductions or losses certified by the partner or state and local taxes paid by the partnership on behalf of the partner), the partnership need not withhold. To be eligible to certify deductions and losses to the partnership, the foreign partner generally must have filed (or will file) U.S. income tax returns reporting income or gains effectively connected with a U.S. trade or business or offsetting deductions or losses for the taxable year in which the certificate is considered and for the prior three years and have paid taxes due under the returns. Treasury Regulation §§ 1.1446-6(b)(1)-(2). Foreign estates and non-grantor trusts generally are ineligible for certification. Treasury Regulation §§ 1.1446-6(b)(3)(ii)-(iii). The regulations prescribe a new form (Form 8804-C) to be used by the foreign partner in certifying deductions and losses. Treasury Regulation § 1.1446-6(c)(2)(i). The partnership must submit the certificate (or updated certificate) with its withholding tax payment voucher (Form 8813) for the first installment period in which the certificate is considered. Treasury Regulation § 1.1446-6(d)(3)(i). For subsequent installment periods in which the certificate is considered, identification of certain information from the certificate, such as the amount of certified deductions and losses, is sufficient. Id. Any certificate considered must accompany the foreign partner’s withholding tax information statement (Form 8805). Treasury Regulation § 1.1446-6(d)(3)(i). A reasonable cause standard applies in the event the partnership does not attach the certificate to the relevant filing in a timely fashion. Treasury Regulation § 1.1446-6(d)(3)(ii). Such oversight must be cured once the partnership becomes aware of its failure to include the certificate. Id.

Generally, an upper-tier partnership receiving certificates from its foreign partners may convey the certificates to a lower-tier partnership for the lower-tier partnership to withhold tax based on the partners in the upper-tier partnership. Treasury Regulation § 1.1446-6(b)(3)(i). The regulations contain rules to prevent more than one partnership from taking into account the same certified deductions and losses. Treasury Regulation §§ 1.1446-6(b)(3)(i)(B)-(C). A foreign partner may only certify deductions (other than charitable deductions) and losses reflected on a tax return filed for the year ending prior to the partnership’s installment due date or the filing date for the Form 8804. Treasury Regulation § 1.1446-6(c)(1)(i)(A). A partner must identify any certified deductions and losses subject to special limitations at the partner level so that the partnership can consider those limitations. Treasury Regulation § 1.1446-6(c)(1)(i)(D). So long

Chapter 5

62

as the AMT is subject to a limit of 90 percent on use of NOL carryovers, a partnership may consider NOLs in an amount no greater than 90 percent of the partner’s allocable share of effectively connected taxable income (reduced by all other certified deductions and losses), a limitation that is applied on a cumulative basis for each installment period. Treasury Regulation § 1.1446-6(c)(1)(i)(C). Regardless of whether it receives a certificate, a partnership may consider 90 percent of state and local taxes paid on the partner’s share of effectively connected taxable income. Treasury Regulation § 1.1446-6(c)(1)(iii).

Upon notification from the IRS that a certificate is defective, the partnership cannot rely on any certificate received from that partner for the taxable year to which the defective certificate relates. Treasury Regulation § 1.1446-6(c)(3). A certificate may be defective for the following reasons: the partner is not eligible to submit a certification under Treasury Regulation §1.1446-6(b); the items of deductions or losses are not described in Treasury Regulation § 1.1446-6(c)(1)(i); the timing requirements for submitting a certificate, an updated certificate or status update under Treasury Regulation § 1.1446-6(c)(2) are not met; the certificate does not include all information required under Treasury Regulation § 1.1446-6(c)(2)(i); a representation made on the certificate is incorrect; the actual amount of deductions and losses is less than the amounts certified to the partnership and considered by the partnership in determining the section 1446 tax; or a failure to comply with any other provision of Treasury Regulation § 1.1446-6. Upon IRS notification that there would be a substantial reduction in section 1446 tax as a result of one or more defective certificates or that a substantial portion of all certificates are defective (or that the IRS lacks information to make this determination), the partnership may no longer rely on any certificates going forward until it receives IRS notification otherwise. Treasury Regulation § 1.1446-6(c)(5). A partnership that relies on a defective certificate generally is liable for the entire amount of section 1446 tax. Treasury Regulation § 1.1446-6(d)(2)(ii)(A). If, however, the defect in the certificate arises from an overstatement or erroneous characterization of the partner’s deductions or losses, the partnership is liable only for the portion of section 1446 tax attributable to the defect. Treasury Regulation § 1.1446-6(d)(2)(ii)(A). In certain circumstances, the partnership may be relieved of additions to section 1446 tax and related interest and penalties. Treasury Regulation § 1.1446-6(d)(2)(ii)(A).


Final regulations issued under section 1446 (see addition to footnote 117 immediately above in this Supplement) require withholding with respect to any amounts of partnership income that are treated as effectively connected with the conduct of a trade or business in the United States (without a requirement that the business be that of the partnership), and state that if a partnership receives from a partner a valid Form W-8ECI (the form used to claim exemption from withholding tax on the ground that income is effectively connected with a U.S. trade or business), then the partner is deemed, for purposes of section 1446, to have effectively connected income subject to withholding under section 1446 to the extent of the items identified on the form. See Treasury Regulation § 1.1446-2(b)(2)(ii). The language which limits this so-called deemed ECI rule to items identified on the form was an addition to the prior rule included in Revenue Procedure 89-31 and could be the basis for not withholding if income from the partnership interest was not identified on the form as ECI. To avoid confusion, it may be advisable in that case for the partner to provide a Form W-8BEN.

8. Election Out of Partnership Rules


Chapter 5

63

Chapter 2, Part I (in this Supplement) describes a two-class trust structure that is commonly used to create synthetic variable rate, tax-exempt bonds. In Revenue Procedure 2003-84, 2003-48 I.R.B. 1159, modifying and superseding Revenue Procedure 2002-68, 2002-2 C.B. 753, which in turn modified and superseded Revenue Procedure 2002-16, 2002-1 C.B. 572, the IRS took the position that these securitization structures are not eligible to elect to be excluded from the provisions of subchapter K because of the existence of more than one ownership class. (There is a grandfathering rule for eligible partnerships (as defined below) having a startup date (the later of the date the entity had multiple owners and the date the entity had more than a de minimis amount of assets) before January 1, 2004 that do not acquire new assets on or after January 1, 2005.) Specifically, the revenue procedure states that the preferred and residual interests in these structures apportion the benefits and burdens of the underlying bonds in a way that differs from direct investment in the bonds. Also, the revenue procedure states that the income allocable to the residual class can be computed only by first computing net income or loss at the entity level and reducing that net income by the income allocable to the preferred class. Having reached this conclusion, the Service then sought to undo the damage by allowing income of an “eligible partnership” that makes a monthly closing election (by providing for the election in its governing documents to which all partners must consent) to be allocated to investors through a monthly closing of the books. An eligible partnership must, among other requirements, provide for allocations of tax items in accordance with section 704(b) and must derive 95 percent of its gross income from (i) interest on tax-exempt bonds or exempt-interest dividends on shares in a mutual fund holding tax-exempt bonds (a somewhat odd way to phrase the requirement because such exempt interest and dividends generally would not be included in gross income), (ii) gains from the disposition of those assets (provided they are original assets of the partnership), and (iii) income from the temporary investment (for a period not longer than 7 months) of proceeds from such dispositions. The monthly closing avoids the timing mismatches that could result from differences in the taxable years of the partnership and investors. The revenue procedure sets out information reporting requirements for an eligible partnership that depart in a number of ways from conventional partnership reporting.144a For example, the partnership must file an abbreviated initial partnership return on Form 1065 but is not generally required thereafter to file annual partnership information returns (provided it complies with the other reporting requirements in the revenue procedure, discussed below). The partnership is required to provide tax information to beneficial or nominee owners of partnership interests or to the IRS on request. The general requirement that a nominee owner of a partnership interest report the identity of the beneficial owner to the partnership is eliminated, but a beneficial owner holding through a nominee must identify itself to the partnership unless the beneficial owner is part of a group of RICs with a common manager and the manager agrees to provide information regarding the beneficial owners to the IRS on request.

Note that while the reasoning of the revenue procedure would apply to any securitization structure that is classified as a partnership and has preferred and residual classes, the relief is granted only for those entities whose income consists almost exclusively of municipal bond interest.

144a Treasury Regulation § 1.6031(a)-1(a)(3)(ii) authorizes the IRS to provide for an

exception to partnership reporting under section 6031 and for conditions for the exception, if all or substantially all of a partnership’s income is derived from the holding or disposition of tax-exempt obligations (as defined in section 1275(a)(3) and Treasury Regulation § 1.1275-1(e)) or shares in a regulated investment company (as defined in section 851(a)) that pays exempt-interest dividends (as defined in section 852(b)(5)).

Chapter 5

64

The authors continue to believe that on appropriate facts, the existence of a second class of equity interests in a partnership holding a fixed pool of assets should not necessarily make an election under section 761 to be excluded from the provisions of subchapter K unavailable. For a discussion of Revenue Procedure 2002-16 and the arguments for permitting certain multiple class partnerships to elect out of subchapter K, see a letter to the Treasury and Service from David Z. Nirenberg, “Re: Elections Under Section 761 for Floating/Inverse Floating Rate Partnerships,” 2002 Tax Notes Today 96-36 (April 30, 2002).

To address a further concern arising from the application of the substantive rules of subchapter K to synthetic variable rate tax-exempt bonds, the Service issued Revenue Procedure 2003-32, 2003-1 C.B. 803, which treats a RIC holding an interest in a partnership holding tax-exempt bonds as if it owned the underlying bonds directly for purposes of qualifying as a RIC and qualifying to pay tax-exempt dividends to its shareholders. Revenue Procedure 2003-32 was amplified and superseded by Revenue Procedure 2005-20, 2005-18 I.R.B. 990, to take account of the fact that Revenue Procedure 2002-68 was modified and superseded by Revenue Procedure 2003-84.

In P.L.R. 200323015 (February 21, 2003), the Service ruled that a trust used to issue synthetic variable rate tax-exempt bonds of a type later addressed in Revenue Procedure 2003-84 (discussed above) would be classified as a partnership and the character of the underlying tax-exempt interest income would pass through to the equity owners. The ruling also concluded that the trust could not elect out of subchapter K for the reasons set out in Revenue Procedure 2003-84 (discussed above).

AJCA 2004 added a new section 1286(f) (discussed in Chapter 4, Part D.6.d. (in this Supplement)), which authorizes regulations applying rules similar to section 1286 and the stripped preferred stock rules (in section 305(e)) to interests in entities or accounts substantially all of the assets of which consist of bonds, preferred stock, or a combination thereof. The legislative history states that this regulation authority is not intended to apply to certain transactions involving direct or indirect interests in entities substantially all of the assets of which consist of tax-exempt obligations. See AJCA 2004 Conference Report, at p. 398.


The IRS has requested public comments regarding the application of conditions (1) through (4) and whether those conditions should be revised, modified, or clarified.131a


See also F.S.A. 200216005 (January 10, 2002) (state-law limited partnership was not eligible to make a section 761 election because partners were not considered to be co-owners of partnership property).

131a See Notice 2004-53, 2004-33 I.R.B. 209. Comments are specifically requested on: (i) the

circumstances under which participants should be treated as owning the property as co-owners; (ii) the facts that should be considered in determining whether participants have reserved the right separately to take or dispose of their underlying shares in the property (e.g., whether an agreement with a third party, such as a lender, that limits the rights of the co-owners to take or dispose of their underlying shares in the investment property would violate this condition); and (iii) the meaning of investment property for purposes of Treasury Regulation § 1.761-2(a)(2) (e.g., whether rental real estate is (or can be) properly treated as investment property for these purposes).

Chapter 5

65

The cross reference in footnote 133 to footnote 135 should be to footnote 136.

D. Other Differences


A partnership interest may or may not be treated as an interest in the underlying partnership property for purposes of various Code rules that require assets of a certain type.152

152 Look-through treatment is provided in various special rules which may imply that there would not

be look-through treatment otherwise. See, e.g., Revenue Procedure 2003-32, 2003-1 C.B. 803 (treating a RIC owning interests in a partnership holding tax-exempt bonds as if it owned the underlying bonds directly for purposes of RIC asset tests), amplified and superseded by Revenue Procedure 2005-20, 2005-18 I.R.B. 990; Revenue Procedure 2003-65, 2003-32 I.R.B. 336 (safe harbor treating a loan secured by an interest in a partnership or disregarded entity holding real property as a loan secured directly by real property for purposes of REIT asset tests).

66

Chapter 6 Qualification and Taxation of REMICs

B. REMIC Qualification Tests

Add the following new paragraphs to the text after footnote 6 (and make the sentence following footnote 6a a separate paragraph):

The 10-day rule has proven to be useful where a REMIC holds distinct pools of mortgages backing different classes of regular interests and transfers the pools on different dates in exchange for related classes. In such a case, the terms of the later-issued regular interests (including, for example, their interest rates) may be determined just prior to the date on which they are actually issued. In these circumstances, it may be advisable to select the last day in the 10-day period on which REMIC interests are issued as the startup day to avoid a technical problem meeting the requirement discussed in Chapter 7, Part B that the terms of a class of regular interests (including the interest rate) be specified on the startup day.

Another issue raised by the 10-day rule is whether it applies only for purposes of the REMIC requirement that REMIC interests be issued on the startup day or also for other Code purposes. For example, is the issue date of a class of regular interests for purposes of accruing original issue discount and other interest income the actual issue date or the day designated as the startup day? Section 860G(a)(9) says that the designation of a day as the startup day applies “for purposes of this paragraph [(9)]” which by virtue of the introductory language of section 860G(a) applies “[f]or purposes of this part [sections 860A-860G].” Treasury Regulation § 1.860G-2(k), however, includes a broader statement: “The day so designated is then the startup day, and all interests are treated as issued on that day.” Given this language, it would be reasonable (and administratively simpler) to treat the designated date as the issue date for all tax purposes.

1. Interests Test

a. Definition of Interest

Add the following new section at the end of Part B.1.a:

(vi) Rights of others in foreclosure property. When a REMIC acquires foreclosure property following a default on a qualified mortgage, the property may be subject to liens or claims in favor of third parties. These may include tax liens, leasehold interests and, where the qualified mortgage was a second mortgage, the lien held by a senior mortgagee. A question arises whether these claims on the property may be treated as interests in the REMIC for purposes of applying the interests test. If the answer were “yes,” then the REMIC would cease to be a REMIC as of the date of acquisition of the property because the interests would be created after the startup day and also would not be REMIC regular or residual interests. Liens that incidentally burden property acquired by a REMIC should be regarded as interests solely in the property and not in the REMIC itself.38a Any other conclusion would mean that a REMIC could not protect its

38a. Compare Treasury Regulation § 1.860D-1(b)(2)(ii) (stripped interests in a mortgage not treated as

interests in a REMIC holding other stripped interests in the same mortgage). The stripped interests case is conceptually easier to address than a lien on real property acquired by a REMIC

Chapter 6

67

claims as a creditor by exercising normal creditor remedies. Further, the REMIC rules clearly contemplate that a REMIC may hold mortgages on property leased by the mortgagor/owner to others38b and mortgages that are second-lien or parity mortgages.38c It would be nonsensical for the REMIC rules to prohibit the normal exercise of creditor remedies by the REMIC in these cases. Thus, a senior mortgage loan should not be treated as an interest in the REMIC itself, but rather as a claim reducing the value of the real estate owned by the REMIC.38d

2. Assets Test.

Comment on footnote 61:

The lack of a rule treating a pre-funding account as a permitted investment was addressed by the AJCA 2004 changes to the definition of qualified reserve fund described in Part B.2.a.(v) (in this Supplement).

a. Qualified Mortgages

(i) Obligations (and interests in obligations).

Add the following at the end of the second sentence of footnote 81:

For private letter rulings treating loans secured by interests in a partnership owing real property as loans secured by real property for purposes of the REIT rules, see Chapter 11, Part B (in this Supplement).

(ii) Principally secured.

The following comment relates to the text after footnote 85:

The text of the book states that the portion of the definition of “principally secured” that looks to the use of substantially all of the proceeds of a loan covers real estate construction or acquisition loans. As indicated in footnote 85, the rule is not well drafted for construction loans because it does not address clearly the treatment of unspent construction funds. Indeed, the preamble to the final regulations, adopting the use-of-proceeds rule, suggests that it was intended to permit the inclusion in a REMIC of home improvement loans without requiring a new

because stripped interests in a debt instrument are treated under general tax principles as a partial ownership interest in the debt instrument. By contrast, liens on real property are not generally regarded as partial ownership interests; instead the owner of the real property owns the whole thing subject to the liens. On the other hand, stripped bonds taken off of mortgages closely resemble the types of financial interests in mortgages that are created as REMIC interests whereas direct interests in real estate are quite different.

38b The rules relating to foreclosure property clearly contemplate that a REMIC may acquire real property subject to a lease or enter into leases on foreclosure property. See Part B.2.b.(iii), below.

38c In determining the value of real property securing a loan for purposes of determining if the loan is a qualified mortgage, the actual market value is reduced by the amount of senior liens and a proportionate amount of parity liens. Treasury Regulation § 1.860G-2(a)(2).

38d Cf. Treasury Regulation § 1.860G-2(a)(2), discussed in footnote 38c, above.

Chapter 6

68

appraisal when funds are disbursed and was not drafted with commercial construction loans in mind.85a

The NYSBA Reforms Report recommends an amendment to the rule, clarifying that it does apply to construction loans. See Attachment, paragraph 9. The report notes that doing so would conform the REMIC definition of qualified mortgage to the closely analogous REIT definition in section 856(c)(3)(B) of “obligations secured by mortgages on real property or interests in real property.” The REIT regulations (Treasury Regulation § 1.856-5(c)) provide that interest on a loan is considered fully derived from such an obligation if the “loan value” of the real property is at least equal to the amount of the loan. The loan value of real property is its fair market value as of the date on which the REIT is committed to make the loan. However, in the case of a construction or improvement loan, the loan value is the fair market value of the land plus the reasonably estimated cost of the improvements or developments (other than personal property) that will be constructed with the proceeds of the loan and will secure the loan.

In P.L.R. 200518033 (February 4, 2005), the IRS accepted a pre-construction appraisal of raw land (reflecting improved, and not as-is, value) and a post-construction replacement cost study of real property improvements comprising an acute care facility obtained in connection with obtaining FHA loan insurance as a basis for establishing the fair market value of the land and newly-constructed real property improvements in applying the 80-percent test in Treasury Regulation § 1.860G-2(a)(1)(i) to a permanent loan secured by the completed facility. The ruling notes that HUD as a loan insurer has a significant interest in establishing the value of property securing loans it insures, and that the rigorous and highly specific requirements of the HUD program are designed to assure an accurate assessment of the value of all components of such security. The permanent loan was created by converting a prior construction loan that was drawn over time to pay construction costs. The ruling indicates that the 80-percent test will be satisfied if the sum of the value of the land as determined by the appraisal and the value of the real property improvements as determined by the replacement cost study is equal to at least 80 percent of the adjusted issued price of the permanent loan amount approved by HUD on conversion of the construction loan.

The following comment applies to the text at footnote 91:

Treasury Regulation § 1.860G-2(a)(2) requires the value of real property to be reduced by “the amount of any lien that is senior to the obligation being tested, and must be further reduced by a proportionate amount of any lien on the real property interest that is in parity with the obligation being tested.” This language is a little confusing in cases in which there is a single lien securing both senior and junior debt. Suppose that a commercial loan in the amount of $10 million is made under a single loan agreement and is secured by a single lien of $10 million. The loan is divided into senior and junior components of $5 million. If the senior and junior components were secured by first and second mortgages of $5 million each, then it would be 85a See the preamble at 1993-1 C.B. 147, 148: “First, in addition to the current 80-percent test, the

final regulations provide an alternative test for determining whether an obligation is principally secured by an interest in real property. Under the alternative test, an obligation is considered to be principally secured by an interest in real property if substantially all of the loan proceeds were used to acquire or to improve or protect an interest in real property and the interest in real property is the only property securing the loan. Thus, for example, a home improvement loan made in accordance with Title I of the National Housing Act would be considered to satisfy the principally secured standard even though one cannot readily demonstrate that the loan satisfies the 80-percent test because a property appraisal was not required at the time the loan was originated.”

Chapter 6

69

clear that the first mortgage lien would be senior to the junior loan. On the actual facts, that result is somewhat uncertain, because there is only one lien. At least where the subordination arises under an agreement to which the borrower is a party, a reasonable argument could be made that contractual subordination of debt should be equated to the creation of a junior lien, but the point is not entirely clear given the language of the regulations.


As a non-tax commercial matter, caution should be exercised in drafting both a qualified mortgage representation and an 80 percent test representation to ensure clarity with respect to whether the “reasonable belief” safe harbor is to be read into the former, and whether the latter is being made for reasons other than ensuring that the loan is a qualified mortgage. See, e.g., LaSalle Bank Nat’l Ass’n v. Nomura Asset Capital Corp., 00 Civ. 8720 (NRB), U.S.D.C. S.D.N.Y., 2004 U.S. Dist. LEXIS 18599, September 13, 2004, Decided, September 14, 2004, Filed, As Corrected, October 4, 2004 (granting the defendants’ cross-motion for summary judgment). The case involved, among other issues, an alleged breach of both a qualified mortgage representation and an 80 percent test representation made by the originator and sponsor in a commercial loan REMIC securitization with respect to one of the loans included in the pool, where the borrower under such loan had subsequently filed for bankruptcy. The qualified mortgage representation had not explicitly excluded the reasonable belief safe harbor, and the court concluded that the defendants had not breached the qualified mortgage representation because the loan was, due to the application of the reasonable belief safe harbor, a qualified mortgage at the time the representation was made. The court also concluded that the separate 80 percent representation was given solely for purposes of determining whether the loan was a qualified mortgage, and was not separate and distinct from the qualified mortgage representation. On appeal, the Second Circuit disagreed (424 F.3d 195 (2d Cir. 1995)), concluding that the 80 percent representation was an independent representation and that the defendants had not satisfied the qualified mortgage representation by virtue of the safe harbor. The appellate court noted that the safe harbor was intended to protect sponsors having no knowledge or reason to know that the qualified mortgage test was not met and questioned whether a sponsor affiliated with the loan originator (the facts before it) would ever lack such knowledge. Also, the qualified mortgage representation was stated to apply “without regard to the rule in Treasury Regulations § 1.860G-2(f)(2) that treats a defective obligation as a qualified mortgage, or any substantially similar successor provision.” The court viewed this qualification as eliminating the safe harbor. The court remanded the case for trial on the valuation question.


See also P.L.R. 200513002 (December 28, 2004).


REMICs have often included commercial mortgage loans involving properties in Maryland where the security is created through an Indemnity Deed of Trust (“IDOT”). In this structure, a loan is made to a trust owned by a real property owner. The trust has no material assets and distributes the loan proceeds to its owner. The owner guarantees the loan obligations of the trust and grants a mortgage over the property to secure the guarantee. In this arragement, the true borrower for federal income tax purposes would be the property owner, because the nominal borrower is a shell and it is clear that the guarantor will pay debt service without a meaninful right of reimbursement from the borrower. The intended purpose of the IDOT arrangement is to reduce mortgage recording taxes which do not apply to obligations of a guarantor.

Chapter 6

70


P.L.R. 200321015 (February 14, 2003) holds that the release of a lien on real property collateral for a loan, in connection with the borrower’s sale of the real property collateral and the defeasance of the borrower’s remaining payment obligations through a deposit of Treasuries, was allowed by the terms of the loan (and thus qualified for the release rule), even though the loan did not actually provide for the release and defeasance. The ruling was premised on the assumption, based on a representation of the taxpayer, that under the applicable state law, a mortgagor could obtain a release of a lien on real property if it provided the mortgagee with the benefit of its bargain. P.L.R. 200648023 (August 17, 2006) concludes that a modification of a defeasance clause to allow a change in the payment terms of government securities comprising a defeasance portfolio did not prevent the defeasance from occurring according to the terms of the mortgage where the change in terms was not a significant modification under section 1001 and the modification is not inconsistent with the anti-abuse purpose of the defeasance rule.


For an article discussing the tax consequences of defeasing commercial mortgage loans, see Blake D. Rubin, Andrea Macintosh Whiteway and Jon G. Finkelstein, “Tax Issues in Defeasing Conduit Loans, Including in LKEs,” 113 Tax Notes 63 (October 2, 2006).

Add the following comment on the text at footnote 107:

Proposed regulations would add a further exception to the release rule for a modification described in Proposed Regulation § 1.860G-2(b)(3)(v) (changes in credit enhancements for a mortgage). This proposed regulation is described in Chapter 6, Part D.2.d (in this Supplement).


The release rule included in the proposed REMIC regulations was identical to the version included in the final regulations. The description of the rule in the preamble to the proposed regulations supports the view that the rule is an anti-abuse measure. The preamble comments as follows on the conditions that must be met to qualify for the defeasance exception from the release rule: “These conditions are intended to ensure that the defeasance transaction is undertaken as part of a customary commercial transaction, and not as part of an arrangement to collateralize a REMIC offering with obligations that are not real estate mortgages.” 1991-2 C.B. 926, 928. Compare the TMP anti-abuse rule discussed in Chapter 4, footnote 237, which, among other things, prevents a taxpayer from avoiding the TMP definition by initially securing a loan with non-mortgage assets and then, as part of a plan, substituting real property collateral. The NYSBA Reforms Report proposes a clarification of the release rule to provide that a release of real property collateral will cause a loan to cease to be a qualified mortgage only if following the release, the loan is no longer principally secured by an interest in real property. As discussed in Part D.2 (in this Supplement), bills have been introduced in the Senate and House that would implement this rule.

Add the following footnote 109a at the end of the sentence in the text that includes footnote 109:

The basic argument is that a “release” as the term is used in the release rule requires a reduction in the total amount of real estate collateral backing a given amount of debt (or stated differently, an increase in the ratio of the loan to the value of real estate collateral). A substitution of real

Chapter 6

71

estate of equivalent value would not involve such a release. In that regard, it is interesting that the regulation under section 1001 (described in the text at footnote 258, below) providing rules for testing when a modification of the collateral for a nonrecourse loan is significant lists separately a release, substitution, addition or other alteration of collateral.

(iii) Real property.

Add the following to the text following the reference to footnote 116:

A loan secured by equity in a partnership or disregarded entity which holds real property likely would be treated as secured by an interest in real property under the same circumstances in which such a loan would be treated as secured by an interest in real property under the REIT rules.116a

In cases in which real property is built for use in a particular business (e.g., a hospital or hotel), a question can arise as to whether there is good will that is separate from the value of the real property interests as defined for tax purposes. However, property is typically valued based on its best use, and the ability of property to generate income, at its particular location and for its intended purpose, should be a very relevant factor in determining the value of the bricks, mortar and dirt. A hospital or hotel loan could also be secured by moveable equipment, which, of course, would not be real property.116b

Add the following new section at the end of Part B.2.a.:

(v) AJCA 2004 changes relating to loan advances and the funding of loan purchases. AJCA 2004 made a number of changes to the definitions of qualified mortgage, qualified reserve fund and regular interest in section 860G, principally to accommodate reverse mortgage loans. They are effective January 1, 2005. The text of the amendments (reflecting a 2005 technical correction) is found in Appendix C (in this Supplement). There are five basic changes:

• A REMIC is allowed to purchase, under a fixed price contract in existence on the startup day, future advances to be made on qualified mortgages pursuant to their original terms.127a The key change here is to allow purchases more than 3 months

116a As indicated above, the REMIC definition of an interest in real property is based on the REIT

rules. Revenue Procedure 2003-65, 2003-32 I.R.B. 336, provides a safe harbor under which a loan from a REIT secured by an interest in a partnership or by the sole membership interest in a disregarded entity which holds real property will be treated as a real estate asset under the REIT rules. For a discussion of Revenue Procedure 2003-65 and related private letter rulings and a ruling on Illinois land trusts, see Chapter 11, Part B (in this Supplement).

116b The Treasury has met with interested parties to discuss REMIC eligibility of loans to finance healthcare facilities guaranteed by FHA under Section 242 of the National Housing Act. See letter to Michael Novey of the Treasury from Peter A. Wessel, Chairman of the Ad hoc FHA 242 REMIC Task Force, August 3, 2007, 2007 Tax Notes Today 153-14 (August 8, 2007), and letter to Michael Desmond and Michael Novey of the Treasury from Michael E. Mazer, August 7, 2007, 2007 Tax Notes Today 158-25 (August 15, 2007). The key issue appears to be whether the loans meet the “principally secured” test.

127a Specifically, the definition of qualified mortgage was amended by adding a new section 860G(a)(3)(A)(iii) which applies to any reverse mortgage loan or other obligation principally secured by an interest in real property that represents an increase in the principal amount under the original terms of an obligation described in clause (i) or (ii) (mortgages transferred on the startup

Chapter 6

72

after the startup day. This change potentially benefits, for example, construction or home equity loans as well as reverse mortgage loans.

• A qualified reserve fund may be used to fund the purchases of future advances described above (or purchases of qualified mortgages within the 3-month period beginning on the startup day otherwise allowed under the REMIC rules), provided the reserve fund does not exceed 50 percent of the aggregate fair market value of all of the assets of the REMIC on the startup day127b (and subject to the additional requirement (as in effect prior to the AJCA 2004 amendments) that amounts in the reserve be promptly and appropriately reduced to the extent they are no longer reasonably required for permitted purposes). A reserve fund could potentially be funded with monies derived from regular interests issued on the startup day, with

day or purchased within 3 months thereafter under a fixed-price contract) if such increase is attributable to an advance made to the obligor pursuant to the original terms of the obligation, occurs after the startup day, and is purchased by the REMIC pursuant to a fixed price contract in effect on the startup day. This language raises a few questions. The requirement that advances be made “pursuant to the original terms” of an obligation should accommodate not only draws that are automatic but also draws that may be made at the option of a borrower. Cf. Treasury Regulation § 1.1001-3(c)(ii) (alterations occurring by operation of the terms of a debt instrument generally include those occurring through exercise of an option). Presumably the reference to “original” terms would not preclude a modification in terms occurring after a loan was originated but before the REMIC commits to buy the loan, as the concern here was likely the activities of the REMIC in modifying loan terms. The reference to an increase in the principal amount “purchased” by the REMIC might be read to mean that a REMIC cannot directly fund an advance, but rather may only buy an advance funded by someone else. See the authorities under section 1281 described in Chapter 4, footnote 309, holding that loans made by a taxpayer to the borrower are not “purchased” or “acquired” by the taxpayer. The requirement that the purchase be made pursuant to a fixed price contract also implies a third party seller (although direct advances might be shoehorned into the language by treating the loan agreement itself as a fixed-price contract). A reverse mortgage loan has a principal balance that increases not only through advances but also through the accrual and nonpayment of interest. It would seem that a REMIC could not purchase more than 3 months after the startup day principal balance increases attributable to interest accruals because they would not be attributable to an advance. Presumably any reasonable means of identifying a principal amount increase that is attributable to advances rather than interest accruals should be accepted. The requirement that an advance be made after the startup day would seem to mean that if loans are acquired as of a cut-off date prior to the startup day, then advances made between the cut-off date and the startup day could not be purchased under the new language. On the other hand, those advances should qualify as loans that could be purchased within the first 3 months after the startup day under section 860G(a)(3)(A)(ii). The new rules place more importance on the term “fixed price contact.” That term is discussed in footnote 65, above.

127b Note that the 50 percent limitation is based on the REMIC’s assets on the startup day, not its assets over time. On the other hand, once a reserve is created it must be reduced “promptly” if no longer reasonably required. The change in the definition of qualified reserve fund addresses the concern under prior law that the qualified mortgage definition allowed purchases within 3 months after the startup day but provided no clear rule preventing the imposition of a 100 percent prohibited transactions tax on income from assets held in a REMIC to fund such purchases. See footnote 61, above.

Chapter 6

73

funds contributed by the holder of the residual interest, or with payments received on qualified mortgages that are held pending reinvestment.127c

• As passed by AJCA 2004, the flush language of section 860G(a)(3) had treated “reverse mortgage loan” (and each balance increase on the loan that could be purchased by the REMIC) as an obligation secured127d by an interest in real property.127e That language was eliminated by the Gulf Opportunity Zone Act of 2005, presumably to make clear that a reverse mortgage loan does not enjoy any special protections in the statute in terms of establishing that it is principally secured by an interest in real property.

• A clarification that a REMIC interest will not fail to be a regular interest solely because the specified principal amount of the regular interest (or interest accrued thereon) can be reduced as a result of the nonoccurrence of 1 or more contingent events with respect to any reverse mortgage loan held by the REMIC if, on the startup day, the sponsor reasonably believes that all such principal and interest will be paid at or prior to the liquidation of the REMIC. According to the legislative history, such reasonable belief will be presumed to exist if, as of the startup day, the interest receives an investment grade rating from at least one nationally recognized statistical rating agency. 127f

• A rule treating government-originated obligations transferred to or purchased by a REMIC as principally secured by an interest in real property if more than 50 percent of those obligations are principally secured by an interest in real property.127g

127c As discussed in Part C.2, below, the 100 percent tax on contributions made to a REMIC after the

startup day has an exception for contributions made to a qualified reserve fund by a residual interest holder.

127d. Note that the original statutory language (at the end of section 860G(a)(3)) did not say that a reverse mortgage loan was treated as “principally secured” by an interest in real property, which is what the definition of qualified mortgage requires, so the original intent was not clear.

127e The term “reverse mortgage loan” is not defined in the statute. The legislative history defines it as a loan that: (1) is secured by an interest in real property, (2) provides for one or more advances of principal to the obligor (each such advance giving rise to a “balance increase”), provided such advances are principally secured by an interest in the same real property as that which secures the loan, (3) may provide for a contingent payment at maturity based upon the value or appreciation in vale of the real property securing the loan, (4) provides for an amount due at maturity that cannot exceed the value, or a specified fraction of the value, of the real property securing the loan, (5) provides that all payments under the loan are due only upon the maturity of the loan, and (6) matures after a fixed term or at the time the obligor ceases to use as a personal residence the real property securing the loan. See AJCA 2004 Conference Report, at p. 412

127f. See AJCA 2004 Conference Report, at pp. 411-412. Presumably the concern was clause (4) of the definition of reverse mortgage loan described in the preceding footnote, which is a term limiting the amount due at maturity to the value, or a specified fraction of the value, of the real property securing the loan.

127g The rule as described in the text (and the statutory text in Appendix C) reflects a technical correction by the Gulf Opportunity Zone Act of 2005. The original language could have been read to protect loans that were not government originated if they were bundled together with government-originated loans.

Chapter 6

74

3. Arrangements Test.


Revenue Ruling 2006-58, 2006-46 I.R.B. 876, clarifies that a charitable remainder trust is a disqualified organization because it is generally exempt from tax and not subject to the tax on UBTI imposed by section 511. For a discussion, see Chapter 9, footnote 89a and accompanying text (in this Supplement).

C. REMIC Taxes

1. Prohibited Transactions Tax

Add the following footnote 175a immediately following the end of the second bullet point on page 386:

Section 860F(a)(2)(A)(ii). Under section 860F, the disposition of a qualified mortgage incident to imminent default is not a prohibited transaction. Avoiding a prohibited transaction through the deemed disposition of a loan in a loan modification requires only a reasonably foreseeable default (not imminent). Treasury Regulation § 1.860G-2(b)(1)(i) provides that if a “significant modification” of a qualified mortgage occurs after the mortgage has been contributed to a REMIC, the modified mortgage is treated as one that was newly issued in exchange for the unmodified mortgage it replaced. Consequently, a significant modification of a mortgage is treated as a disposition and, unless the modified mortgage is a qualified replacement mortgage (as discussed in Part B.2.a.iv. above), such deemed disposition would result in a prohibited transaction. However, Treasury Regulation § 1.860G-2(b)(3) provides that for purposes of Treasury Regulation § 1.860G-2(b)(1), the term “significant modification” does not include changes in the terms of a mortgage occasioned by default or reasonably foreseeable default. Further, Treasury Regulation § 1.860G-2(b)(4) provides that if a mortgage is modified and the modification is not a significant modification, then the modified mortgage is not treated as having been newly originated on the date of such modification. Thus, it seems that the modification of a mortgage for which default is reasonably foreseeable would not give rise to a prohibited transaction because such modification is not considered a significant modification for purposes of Treasury Regulation § 1.860G-2(b)(1)(i).


The 2006-2007 IRS Business Plan had included “[p]roposed regulations under section 7872(c)(1)(E) regarding significant effect loans and section 7872(g) regarding loans to qualified continuing care facilities.” This item has not been included in subsequent business plans. The 2005-2006 IRS Business Plan contained the same item and the 2004-2005 IRS Business Plan had included “[p]roposed regulations under section 7872.”

3. Tax on Income From Foreclosure Property


In Revenue Ruling 2004-24, 2004-10 I.R.B. 550, the IRS discusses circumstances in which a REIT’s income from providing parking facilities at its rental properties qualifies as rents from real property.

Chapter 6

75

D. Special Topics

Add the following to the list of topics on page 395:

• REMIC regular interests as investments in United States property.

1. Credit Enhancement Contracts

a. Definition of Credit Enhancement Contract

Chapter 2, Part E (in this Supplement) describes a new type of REMIC regular interest referred to as a GFM Class. The structure provides a guaranteed final maturity date for a class of regular interests that is earlier than the date on which they would be retired if the qualified mortgages held by the REMIC were not prepaid at all. Either a GFM Class is the sole class of regular interests issued or all other classes of regular interests are expected to be retired prior to the Fixed Payment Date, even assuming that there are no prepayments on the qualified mortgages. The structure involves the sale of any remaining qualified mortgages on a Sale Date during the liquidation period for a qualified liquidation. The sale would either be at a price equal to the face amount of the mortgages pursuant to the exercise of a Liquidation Call (a call option written by the REMIC) or if the Liquidation Call is not exercised, would be at a fair market value price. The sponsor or someone else would enter into a Shortfall Agreement providing for contributions to the REMIC of any excess of the face amount of the qualified mortgages over their sale price. (The Liquidation Call may be separated from the Shortfall Agreement to allow the sponsor to achieve an accounting sale if it is the one who enters into the Shortfall Agreement.)

The Liquidation Call written by the REMIC would not be an asset of the REMIC and would not be a prohibited interest in the REMIC because of the rule described in Chapter 6, Part B.1.a.(iv), that excludes from the definition of interest a right to purchase mortgages pursuant to a qualified liquidation. If the Liquidation Call is exercised, any gain on the sale of mortgages would not be a prohibited transaction, because the gain would be attributable to a sale of mortgages and would occur pursuant to a qualified liquidation. If the option were to expire unexercised, gain equal to the option premium would not be subject to the prohibited transactions tax because it would not be attributable to a REMIC asset or represent a fee for services.

The Shortfall Agreement could be viewed one of two ways, either as a current asset of the REMIC or, less likely, as an agreement that provides for future contributions to the REMIC but is not a current asset. If it is an asset, then it could potentially qualify as a credit enhancement contract. The definition of that term includes a contract that guarantees payments on REMIC regular interests in the event of unanticipated losses incurred by the REMIC. The Shortfall Agreement would meet this definition if the shortfall it makes up is a loss to the REMIC (which it should be, at least if the REMIC’s basis in the qualified mortgages equals or exceeds their principal amount) and the loss is “unanticipated.” Accordingly, it would seem to be necessary in order to meet this part of the definition to show that the sale of the qualified mortgages at a loss is unanticipated, for example, because all of the qualified mortgages are expected to be repaid prior to the Sale Date or because the likelihood that any remaining mortgages would be sold at a loss is small.

Alternatively, the Shortfall Agreement might be considered an arrangement for making future contributions to the REMIC. Such contributions should not be subject to the 100 percent contribution tax discussed in Part C.2, above, because they should be considered to be made to

Chapter 6

76

facilitate a qualified liquidation. If the party contributing the funds is not the holder of the residual interest in the REMIC, then the contribution should be income to the REMIC, but any such income would simply offset the loss on sale. The income should not be subject to the prohibited transactions tax because it should be considered to be attributable to the sale of a qualified mortgage.

2. Modifications and Assumptions of Mortgages

c. Material Modifications


The 2001 IRS Business Plan had included a “[s]tudy [of the] section 1001 regulations regarding modification of debt instruments” as a project to which substantial resources would be committed during the plan year ending June 30, 2002, but which was expected to be completed by June 30, 2003. However, this study was not included in subsequent business plans, so it appears the project has been dropped.

(i) Definition of “modification”


P.L.R. 200315001 (September 19, 2002) addresses the modification rules in the context of a corporate restructuring in which a corporate debtor (i) became a wholly owned subsidiary of a newly formed parent, (ii) converted into a limited liability company under state law, (iii) changed its tax status from a corporation to a disregarded entity, and (iv) transferred its interests in various international subsidiaries to a newly formed sister limited liability company. The ruling held that neither the conversion of the corporation into a limited liability company nor the distribution of assets by the newly converted limited liability company was a modification of recourse debt issued by the corporation because neither changed the legal rights or obligations of the parties under state law (stating that the legal rights or obligations referred to in Treasury Regulation § 1.1001-3(c) are those determined under state law). Another ruling to the same effect is P.L.R. 200630002 (April 24, 2006). For further discussion of this fact pattern, see James M. Peaslee, “Modifications of Nondebt Financial Instruments as Deemed Exchanges,” Tax Notes, April 29, 2002, 737 (see Part IV.A).


Note that the list of deemed modifications does not include changes in the collateral for a loan. Thus, a complete substitution of collateral for a nonrecourse loan made according to the terms of the loan would not seem to involve a modification even though the asset supporting the debtor’s repayment obligation has changed completely. Similarly, neither the removal of excess collateral, nor the substitution of insurance proceeds for property as collateral following a casualty, would involve loan modifications if made according to the terms of a debt instrument.

Add the following new footnote 237a at the end of the parenthetical “(or under applicable law)” in the first bulleted paragraph on page 408:

In P.L.R. 200321015 (February 14, 2003), the Service concluded that a borrower held a unilateral option to defease a loan under applicable law where the terms of the loan did not provide for the defeasance but the taxpayer represented that the highest court in the state had held

Chapter 6

77

that a mortgagor can obtain a release of a lien on real property if the mortgagor provides the mortgagee with the benefit of its bargain.

Add the following new footnote 258a at the end of the sentence ending in line five with “particular type and rating)”.

P.L.R. 200648023 (August 17, 2006) relied on the fungible collateral exception in concluding that, for a mortgage loan that could be defeased with government securities, a change in the permitted securities from those maturing as close as possible to a debt service payment date to those maturing within 12 months prior to such date was not a significant modification.

d. REMIC Regulations


On November 9, 2007, the IRS issued proposed regulations that would add two categories of modifications (new clauses (v) and (vi)) to the list of safe-harbor loan modifications in Treasury Regulation § 1.860G-2(b)(3). The new categories would be as follows:

• A modification that releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a recourse or nonrecourse obligation, so long as the obligation continues to be principally secured by an interest in real property following such release, substitution, addition or other alteration;273a and

• A change in the nature of the obligation from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), so long as the obligation continues to be principally secured by an interest in real property following such a change.

Under Proposed Regulation § 1.860G-2(b)(7), in determining whether an obligation continues to be principally secured by an interest in real property for purposes of the two new safe harbor rules, the fair market value of the interest in real property securing the obligation, determined as of the date of the modification, must be equal to at least 80 percent of the adjusted issue price of the modified obligation, determined as of the date of the modification. Further, the fair market value of the interest in real property securing the obligation must be determined by an appraisal performed by an independent appraiser. This rule appears to require an appraisal in all events, regardless of whether: (1) the modification involves the addition or release of real property collateral, (2) the sufficiency of the real property collateral is obvious without an appraisal, and (3) prior to the modification, the loan was a qualified mortgage under the 80 percent test of Treasury Regulation § 1.860G-2(a)(1)(i) or the alternative test of Treasury Regulation § 1.860G-2(a)(1)(ii) (substantially all of the proceeds of the mortgage were used to acquire, improve or protect an interest in real property, which serves as the sole security for the mortgage at origination). The 80 percent valuation test based on an appraisal seems excessive, 273a Proposed Regulation § 1.860G-2(a)(8)(i) would treat a modification that is permitted under

Proposed Regulation § 1.860G-2(b)(3)(v) as not an impermissible release of the lien on real property for the REMIC asset test. The IRS should clarify that the cross-reference to the safe harbor rule allowing modifications of collateral subject to an updated appraisal (see below in the text) does not have the effect of curtailing the generally accepted practice of allowing partial releases of collateral for a commercial mortgage in connection with a partial prepayment of a mortgage based on pre-agreed release prices for the collateral.

Chapter 6

78

particularly where the modification does not affect the adequacy of real property collateral. The government should keep in mind that the overall purpose of the 80 percent requirement is only to determine broadly if a loan is a real property mortgage. Thus, the 80 percent test is quite unlike a determination of value under section 170 (charitable deduction), where a taxpayer is claiming a deduction for the value of contributed property and there is strong tax policy reason for requiring accurate valuations confirmed through appraisals.

The proposed regulations do not include a number of exceptions requested by representatives of the mortgage industry and other commentators that appear to be noncontroversial to the authors (at least in terms of what a REMIC should be allowed to do without becoming too active to justify pass-through treatment). For example, in a letter to the Service dated April 30, 2007, the Mortgage Bankers Association and eight other industry groups submitted a draft proposed amendment to the REMIC regulations and a supporting policy memorandum. The letter indicated that the changes in the proposed amendment were necessary to accommodate the development of the commercial mortgage-backed securities market (the MBS market was largely confined to residential loans when the current REMIC rules and regulations were issued). The proposed amendment would have added the following exceptions to the current list of four permitted modifications of qualified mortgages by REMICs in Treasury Regulation § 1.860G-2(b)(3):273b

• a change in the date on which the obligation may be prepaid or defeased in whole or in part, or addition of a defeasance provision that meets the requirements of Treasury Regulation § 1.860G-2(a)(8);

• a substitution of a new obligor or addition or deletion of a co-obligor on the obligation;

• an imposition or waiver of a prepayment penalty or other fee; and

• a change of the principal payment schedule of a loan following a voluntary or involuntary prepayment of principal.

The proposed amendment also would have extended the REMIC modification exceptions to grantor trusts. The proposed regulations, however, only apply to REMICs. The preamble to the proposed regulations includes a discussion of the reasons why the IRS and Treasury believed that the proposed additional changes were either not needed or unwarranted.

The proposed regulations represent one step (and hopefully not the final one) in a long process of trying to change the REMIC and grantor trust rules to accommodate relatively routine modifications of commercial mortgage loans. A summary of the recent history follows.

In December 2002, the New York State Bar Association, Tax Section proposed a change in the REMIC regulations that would disregard a modification of a qualified mortgage if the modification does not extend the final maturity date, increase the principal amount, or release real

273b The proposed amendment included the two exceptions added by the proposed regulations but did

not provide for the continues-to-be-secured-by-an interest-in-real-property requirement. Instead, a modification would be excluded from the exception if it caused the obligation not to be principally secured by an interest in real property.

Chapter 6

79

property collateral such that the obligation is no longer principally secured by real property.273c Bills were introduced in 2004 in the House (H.R. 4113) and Senate (S. 2422) that would have created a statutory safe harbor rule along these lines. The bills were reintroduced in 2005 (H.R. 1010 and S. 580). The bills were never reported out of the House Ways and Means Committee or Senate Finance Committee. With the legislative efforts not succeeding, a letter was sent to the Treasury on behalf of the Mortgage Bankers Association requesting that the REMIC and grantor trust regulations be changed to expressly allow, without running afoul of REMIC or grantor trust rules, certain specified modifications to a loan that do not increase its principal amount or extend its maturity date, cause it to cease to be principally secured by real property, or change its interest rate.273d

The next event (a positive one) was the Service’s announcement in Notice 2007-17, 2007-12 I.R.B. 748, that it was launching a pilot program to solicit greater input from the public in the initial development of certain guidance projects. Under the program, the government would publish a notice for each guidance project selected for the program. The notice would identify research, background documents, drafts of proposed guidance and other work products, and ask interested parties to provide them. These written submissions would help the government determine whether it is appropriate to publish guidance. As a model for the program, the IRS and Treasury solicited input in the Notice on whether it was appropriate to amend existing income tax regulations to permit certain modifications of securitized commercial mortgage loans. The Notice requested draft changes to the REMIC regulations and a policy memorandum addressing a long list of issues.273e The April 30, 2007 letter described above from the Mortgage Bankers

273c 98 Tax Notes 795 (Special Supplement, February 10, 2003). 273d See Letter to Eric Solomon from Kenneth J. Kies, June 28, 2006, 2006 Tax Notes Today 133-24. 273e The Notice asks that the memorandum discuss the following fourteen topics: (1) the evolution of

market practices in the securitization of commercial mortgages in REMIC form; (2) the relevant REMIC policy considerations affecting restrictions on mortgage loan modifications; (3) the authority under current law for amending the regulations to include exceptions for commercial mortgages; (4) the relationship between the section 1001 modification rules and the separate REMIC modification rules; (5) an analysis of the extent to which the four existing exceptions for mortgages and any proposed exceptions for commercial mortgages constitute departures from the section 1001 modification rules; (6) the purpose and background of the four existing exceptions for modifications of mortgages in the REMIC modification rules (including policies that might favor allowing assumptions and waivers of due on sale clauses in programs intending to assist residential housing acquisitions (e.g., tax-exempt single family housing bonds, VA & FHA insured mortgages)); (7) examples of what are considered to be common changes requested by borrowers to the terms of commercial mortgages and an explanation of why such changes are requested by borrowers; (8) an explanation of each proposed exception for commercial mortgages, including (i) how each proposed exception is consistent with the underlying existing regulatory provisions and Congressional intent in enacting the REMIC rules, (ii) whether the proposed exception relates to a common change; and (iii) how each proposed exception would accommodate a legitimate business concern; (9) each proposed exception illustrated by one or more examples; (10) whether there are alternatives to resolve industry issues related to commercial mortgage loan modifications other than through amending the regulations and the feasibility of such alternatives (e.g., drafting documents to permit certain changes to the terms of a commercial mortgage loan to avoid triggering a significant modification under Treasury Regulation § 1.1001-3); (11) identification of the types of taxpayers and other interested persons who are affected by the inability to modify commercial mortgage loans once the loan is placed in a REMIC and how they are affected; (12) an estimate of how many taxpayers and other interested persons are directly and indirectly affected by an inability to modify commercial mortgage loans; (13) potential consequences to the industry if changes are not made to the regulations to permit

Chapter 6

80

Association and others outlining proposed regulation changes was submitted in response to Notice 2007-17.

Notice 2007-17 also inspired an off-beat March 9, 2007 New York Times article that criticized the Notice on the ground that the IRS was allowing the foxes to design the hen house (David Cay Johnston, “I.R.S. Letting Tax Lawyers Write Rules”). This in turn led Senators Grassley and Baucus to express concerns about the program and write letters asking for information about it. See 2007 Tax Notes Today 52-3 (March 15, 2007). It seems fairly clear that the journalist and politicians commenting on the Notice did not appreciate the fact that crafting mortgage servicing standards for commercial mortgages was unlikely to provide feeding opportunities for foxes (tax shelter promoters).

As a result of increased mortgage defaults and foreclosures and resulting pressures on loan servicers to grant relief to debtors, a number of industry initiatives were developed starting in 2007 to grant relief to debtors that are likely to default, whether or not a default has actually occurred. In late 2007 and in 2008, the IRS issued guidance generally allowing servicers of loans held in REMICs and grantor trusts to modify loans under such programs without fear that the modifications will result in disqualification of a trust as a REMIC or grantor trust, or in the case of a REMIC, imposition of a prohibited transaction tax. The main significance of the guidance is that it avoids the need for loan-by-loan assessments of default risk.

Revenue Procedure 2007-72, 2007-52 I.R.B. 1257, which was superseded by Revenue Procedure 2008-47, 2008-31 I.R.B. 272, applies to modifications of subprime adjustable rate loans in accordance with the American Securitization Forum’s (“ASF”) recommended guidelines for modifications of adjustable rate mortgages. The guidelines (“Statement of Principles, Recommendations and Guidelines for a Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans,” referred to in the revenue procedures as the “ASF Framework”) were originally issued on December 6, 2007 and were updated July 8, 2008 (necessitating the revised IRS guidance). The modifications must be conducted in accordance with the fast track procedure outlined in the ASF Framework for modifying loans in advance of the initial, or any subsequent, interest rate reset date. Under that procedure, a servicer may freeze the interest rate typically for five years from the date at which the rate would otherwise have reset in the absence of the modification (or a second-lien holder’s subordination of its lien). The revenue procedure applies to transactions occurring on or before July 31, 2010 for fast track modifications pursuant to the ASF Framework and a second lien holder’s subordination of its lien to a new lien resulting from the fast track modification. The ASF Framework covers generally first-lien residential adjustable rate mortgage loans that (i) were originated between January 1, 2005, and July 31, 2007; (ii) are included in securitization pools; (iii) have an initial interest rate period of three years or less; and (iv) have an initial interest rate that resets between January 1, 2008, and July 31, 2010.

Revenue Procedure 2008-28, 2008-23 I.R.B. 1054, applies to modifications made pursuant to certain programs developed by servicers to identify high risk mortgage loans. In order to qualify for the relief, all of the following conditions must be satisfied:

certain changes to the terms of the commercial mortgage loans; and (14) because some or all of the proposed exceptions for commercial mortgage loans will likely constitute a significant modification under section 1.1001-3, a discussion of the resulting tax consequences to the REMIC of deemed exchange treatment under section 1001 (e.g., how would the existing REMIC rules treat a gain or loss from a deemed exchange).

Chapter 6

81

• the real property securing the loan must contain fewer than five dwelling units and must be owner-occupied;

• in the case of a REMIC, no more than 10 percent of the principal amount of its assets can consist of loans with payments overdue by 30 days or more as of the REMIC’s startup day (or the end of the 3 month period beginning on the startup day), and in the case of an investment trust, no more than 10 percent of the principal amount of debt instruments held by the trust can consist of instruments with payments overdue by 30 days or more as of all dates when assets were contributed to the trust;

• the trust, REMIC or servicer “reasonably believes that there is a significant risk of foreclosure,” which belief may be “based on guidelines developed as part of a foreclosure prevention program;”273f

• the terms of the modified loan are less favorable to the holder than the unmodified loan; and

• the trust, REMIC or servicer reasonably believes that the modified loan results in a substantially reduced risk of foreclosure.

Industry associations have suggested changes and clarifications to Revenue Procedure 2008-28 that generally would expand its scope.273g The commentators seek to expand the scope of mortgage loans covered to include loans secured by co-ops and condominiums. Further, they request additional guidance that would (i) clarify that both first and second liens are covered; (ii) allow servicers to rely on owner-occupied status at origination, unless the servicer has information otherwise; (iii) increase the permissible amount of delinquent loans from 10% to at least 20%, but preferably 50%; and (iii) clarify that the start-up day or contribution date be deemed to reflect information as of a specified date within 30 days of the actual closing or contribution date. Finally, the associations feel that because the revenue procedure reflects general principles for concluding that default is reasonably foreseeable if its factual conditions are met, the revenue procedure should not expire.

3. Convertible Mortgages

Add the following at the end of Part D.3:

The regulations define a convertible mortgage as one that is convertible to a different rate at the election of the mortgagor. Thus, a hybrid ARM, a mortgage that converts automatically from a fixed rate to a floating rate (or one floating rate to another) arguably might not satisfy the definition. If such a reading of the regulations were correct, a sale of such a mortgage upon conversion would appear to be a prohibited transaction.281a On the other hand, most such

273f It seems that the risk of foreclosure need not be immediate, as the Revenue Procedure describes

foreclosure prevention programs that can “assess with a high degree of accuracy whether a borrower presents an unacceptably high risk of eventual foreclosure.” (emphasis added)

273g See 2008 Tax Notes Today 149-15 (July 15, 2008) (letter from the American Securitization Forum); 2008 Tax Notes Today 149-16 (July 15, 2008) (letter from the Consumer Mortgage Coalition and the Mortgage Bankers Association).

281a Failure of a mortgage to be a convertible mortgage would also remove the protection of Treasury Regulation § 1.860D-1(b)(2)(iv), which provides that a right or obligation to acquire a convertible

Chapter 6

82

mortgages are prepayable at the option of the borrower so that continuation of the mortgagor following conversion does reflect a borrower choice. For those looking for assurance and having little fear of the multiplication of REMICs, one approach might be to have a separate REMIC for each mortgage (or for each group of mortgage loans having a conversion date within the same 90-day period) and then liquidate the individual REMICs when the related mortgages convert. The sale would then be pursuant to a plan of liquidation of the REMIC holding the mortgages.281b

6. Financially Distressed Mortgages

b. Pre-Acquisition Defaults

Add the following at the end of the sentence following the citation to Revenue Ruling 80-280 in footnote 304:



The NYSBA Reforms Report proposes safe-harbor rules to be used in applying the improper knowledge test. See Attachment, paragraph 12.

As described in Part D.6, the REMIC rules accommodate modifications or dispositions of defaulted mortgages. As described in Part D.2.d, the REMIC rules allow a REMIC to modify a qualified mortgage if, among other things, the modification is occasioned by default or a reasonably foreseeable default.

The recent crisis in the mortgage markets has led to the development of industry-wide and governmental efforts to encourage loan servicers to offer loan modifications to certain categories of borrowers as a way of avoiding foreclosure. These programs raised a question whether there was sufficient information with respect to individual loans to conclude that a modification was occasioned by a reasonably foreseeable default. Part D.2.d (in this Supplement) describes guidance the IRS has issued to ensure that modifications made pursuant to certain of these programs will not have adverse tax consequences under the REMIC or grantor trust rules.

mortgage upon a conversion is not an impermissible interest in the REMIC. However, a purchase agreement in respect of a hybrid ARM would not necessarily be an impermissible interest in a REMIC under the general definition. See, generally, Chapter 6, Part B.1. Also, the use of individual REMICs, as suggested immediately below in the text, would allow a purchase agreement to fall within Treasury Regulation § 1.860D-1(b)(2)(iv) (excludes from REMIC interest a right or obligation to acquire mortgages in connection with a qualified liquidation).

Although the sale of a such a mortgage (absent the use of individual REMICs) would appear to be a prohibited transaction, assuming that the rate on conversion is determined in a manner expected to result in the mortgage having a value of par, there may be no adverse consequences to such a sale. Under the general OID rules or the PAC method, any unaccrued market discount and OID would generally accrue upon conversion so that there would be no gain or loss on a post conversion sale at par. Cf. Treasury Regulation § 1.1275-5(f) (for purposes of accruing OID, certain reset bonds are treated as (1) maturing on the date immediately preceding the reset effective date for an amount equal to the reset value and (2) being reissued on the reset effective date for an amount equal to the reset value).

281b Liquidations of REMICs are discussed in Chapter 6, Part B.1.a.(iv).

Chapter 6

83

The guidance includes Revenue Procedure 2008-28. One of the requirements of this revenue procedure is that not more than 10 percent of the qualified mortgages contributed to a REMIC be more than 30 days delinquent at the time of contribution. Obviously, the IRS wanted to provide relief only for REMICs for which default-related loan modifications were unanticipated when the REMIC was formed.

At an American Bar Association Section of Taxation, Financial Transactions Committee meeting on September 12, 2008, an IRS official expressed some concern over the use of REMICs to hold already defaulted loans. An article reporting on the meeting included the following (see 2008 Tax Notes Today 182-3):

Diana Imholtz, an attorney in the IRS Office of Associate Chief Counsel (Financial Institutions and Products), and James A. Gouwar of McKee Nelson LLP, told the Financial Transactions Committee that the guidance [on loan modifications by REMICs] does not cover formation of a ‘workout factory’ -- a new REMIC full of dodgy loans that are awaiting modification. The IRS has not made a technical statement about whether forming a workout factory would qualify for REMIC status, Imholtz and Gouwar emphasized. Not too many people are forming subprime REMICs, they noted. So more guidance would only come if this became a problem. A REMIC is supposed to be a static pool of mortgages, while a workout factory might look more like a business, Imholtz said.

Consistent with Ms. Imholtz’s statement, the 2008-2009 Business Plan does not list the modification of the REMIC rules to address non-performing mortgage loans as an issue to be addressed in future regulations.

A REMIC could be used to acquire and modify loans that are already more than 30 days delinquent in two circumstances. First, where the loans are being financed with time-tranched debt and it is not clear if the entity holding the loans would qualify for the vaguely worded exception to the TMP rules for “seriously impaired loans” (the exception is discussed in Chapter 4, Part E.2.e). Second, such a REMIC might be used by foreign investors seeking to acquire non-performing loans for the purpose of modifying them because of a concern that engaging in such activities directly may cause the foreign investors to be treated as engaged in a United States trade or business, resulting in the imposition of a U.S. net income tax. A REMIC used to acquire seriously delinquent mortgages likely could not be used to acquire foreclosure property because of the “improper knowledge” rule discussed above. Accordingly, the investment structure would need to provide for a sale of loans before their conversion into foreclosure property.

As discussed in Chapter 13, Part D.2, a taxpayer whose activities are limited to effecting transactions in securities generally qualifies for the trading-in-securities safe harbor and is not (on account of those activities) treated as engaged in a United States trade or business. The trading-in-securities safe harbor, however, does not apply to (1) a dealer in securities or (2) the active conduct of a “banking, financing or similar business.”312a The modification of a loan, even if treated as a debt-for-debt exchange, is almost certainly not a dealer activity because it does not

312a Chapter 13, Part D.3.b. discusses the types of lending activities that may fall outside of the

securities trading safe harbor. Strictly speaking, it may be possible to have a lending business that falls outside of the securities trading safe harbor but is not the “active conduct of a banking, financing or simiar business” as that term is used in section 864. However, the term captures well the kind of customer driven financial business activities that are likely to cause trouble whether or not it technically applies.

Chapter 6

84

involve a sale of property to a customer with a merchandising mark-up.312b However, there is a modest, but nonetheless nontrivial, risk that modifying a loan may be treated as a “banking, financing or similar business” since the modification is treated as the issuance of a new loan for tax purposes.312c

The concern that foreign investors may be viewed as engaged in a United States trade or business is alleviated if the mortgages are held by a REMIC and the foreign investors hold (directly or through an investment vehicle) only REMIC regular interests that by statute are treated as debt of the REMIC. It would be difficult to attribute workout activities of a REMIC to REMIC creditors.312d

While the drafters of the REMIC regulations likely did not contemplate the use of REMICs for the purpose of working out pools of nonperforming loans, with one exception, the various rules in the regulations and statute relating to defaulted loans and modifications of defaulted loans do not by their terms require that the default arise before the REMIC startup day. The exception is the improper knowledge rule limiting the definition of foreclosure property. Further, the rule in Treasury Regulation § 1.860G-2(b)(3)(i) allowing a REMIC to ignore a default-related modification in testing the status of a loan as a qualified mortgage is clearly intended to apply to pre-acquisition modifications (see Treasury Regulation § 1.860G-2(b)(1)(ii) which addresses pre-acquisition modifications); and the rule in Treasury Regulation § 1.860G-2(a)(7) that defines an “obligation” to be any instrument with noncontingent principal at least equal to its issue price without requiring that it be debt for tax purposes also mitigates the effect of pre-acquisition events affecting the tax status of a loan. In any event, a modification of a loan is not a prohibited

312b Cf. Stephens, Inc. v. United States, 464 F.2d 53 (8th Cir. 1972), cert. denied, 409 U.S. 1118 (1973)

(acquiring control of corporations for purposes of managing and restructuring their operations is not a dealer activity); Kemon v. Commissioner, 16 T.C. 1026 (1951) (taxpayer that acquires distressed securities to gain control of corporations to effect liquidations, restructurings or sales of assets characterized as activities of a “trader holding [securities] primarily for speculation or investment”). Note that the dealer exception to the securities trading safe harbor applies the traditional dealer definition under section 1221(a)(1) and not the expanded definition in section 475 that includes taxpayers purchasing securities from customers (that definition is discussed in Chapter 11, Part F.2). See Treasury Regulation § 1.864-2(c)(2)(iv).

312c Modifications of mortgages and the effects of Treasury Regulation § 1.1001-3 are discussed in Chapter 6, Part D.2. The active conduct of a banking, financing or similar business as defined in Treasury Regulation § 1.864-4(c)(5)(i) requires “[m]aking personal, mortgage…or other loans to the public” (emphasis added). Significant arguments can be made that (i) a group comprised solely of the mortgagors on a pool of mortgages acquired in the secondary market do not qualify as “the public” and (ii) modifying an existing loan acquired in the secondary market to enhance the value of the exiting loan without providing new funds is not the “making” of a loan.

312d Using a REMIC may also produce tax disadvantages. Mortgage loans subject to workouts are purchased at discounts and phantom income often arises when mortgage loans are modified because the lender is treated as receiving the issue price of the new, post-modification loan in exchange for the old, pre-modification loan. With limited exception, under sections 1273(b)(4) and 1274, the issue price of a modified loan is its unpaid principal balance, not its fair market value. See also Treasury Regulation §§ 1.1273-2(d)(1) and 1.1274-2(b). Using a REMIC shifts the phantom income from foreign investors that likely will not be subject to net income tax in the United States to the REMIC residual interest holder who always will be subject to net income tax in the United States.

Chapter 6

85

transaction because it does not involve a disposition (wholly apart from whether it would fall into the defaulted mortgage exception).312e

In the REIT context, the IRS, after some waffling, decided not to impose non-statutory limitations on activities of a REIT. See, e.g., G.C.M. 37708 (Sept. 29, 1978) (in holding that a REIT can operate an insurance business, “[w]e do not favor the adoption of a qualitative nonpassive income source test under section 856. In the formulation of the REIT provisions, Congress took ‘care to draw a sharp line between passive investments and the active operation of business,’ H.R. Rep. No. 2020, 86th Cong., 2d Sess. 4 (1960), by prescribing a detailed set of statutory rules. For this reason, we believe a requirement not expressly provided in the statute should not be lightly inferred.”); G.C.M. 38090, (Sept. 12, 1979) (in holding that a REIT may hold certain mortgage notes as ordinary assets acquired in the ordinary course of a trade or business, “[the REIT] is engaged in the business activity of rendering the service of making loans, for which service it receives notes and mortgages as evidences of indebtedness. If the REIT otherwise qualifies as a REIT by meeting the technical requirements of the REIT provisions…it should not, under the rationale of G.C.M. 37708, be disqualified on the basis of a qualitative test not expressly provided in the statutory scheme.”); G.C.M. 38238 (January 9, 1980) (in discussing certain so-called rehypothecation loans, “[t]hat a REIT may generally engage in the active conduct of a trade or business so long as the literal requirements of the Code are satisfied is now an established office position.”).

A further practical consideration is whether the IRS would choose at this point to cut off a potentially significant source of financing for the mortgage markets by mounting an attack on REMICs used to acquire nonperforming loans. Of course, that kind of practical consideration may not be worth much in responding to an audit a few years hence in (hopefully) happier economic times.

7. Integration

c. Packaging REMIC Interests With Other Financial Instruments

The NYSBA Reforms Report recommends allowing a REMIC to integrate qualified mortgages with hedges. See Attachment, paragraph 13.

Add the following new section D.8. at the end of Part D on page 442:

8. REMIC Regular Interests as Investment in United States Property

As discussed in Chapter 13, Part G.5, a CFC is generally a foreign corporation that is more than half owned by United States shareholders (United States persons owning 10 percent or more of the voting stock). CFCs are subject to anti-deferral rules that tax certain items of income to their United States shareholders before those items are distributed. One such rule is found in section 956, which treats a CFC as distributing to its United States shareholders their share of the

312e A loan repayment is not considered a “disposition” (see footnote 180, above, and accompanying

text). It would seem that this rule should apply to a deemed repayment through a modification. If a modified loan were sold to another holder at a gain prior to the liquidation of a REMIC, it would be necessary to show that the disposition is “pursuant to a disposition incident to the foreclosure, default, or imminent default of the mortgage” within the meaning of section 860F(a)(2)(A)(ii) to avoid a prohibited transaction tax.

Chapter 6

86

earnings of the CFC that are invested in United States property. The definition of United States property includes, inter alia, an “obligation of a United States person” (see section 956(c)(1)(C)), subject to certain exceptions in section 956(c)(2). This list of exceptions was expanded in AJCA 2004 in a way that helps clarify the treatment of REMIC regular interests. As explained below, a REMIC regular interest should not be considered an investment in United States property if both the holders of the REMIC residual interest and the mortgagors with respect to the qualified mortgages held by the REMIC are unrelated to the CFC.

The definition of an obligation of a United States person in the accompanying regulations refers to section 957(d) (re-designated as section 957(c) by AJCA 2004) for the definition of United States person.333a Section 957(c), in turn, defines a United States person by reference to section 7701(a)(30) with exceptions not relevant here. Section 7701(a)(30) defines a United States person as a citizen or resident of the United States, a domestic partnership, a domestic corporation and certain estates and trusts. Section 956(c)(2)(F) excludes from the definition of United States property of a CFC the stock or obligations of a domestic corporation which is not a United States shareholder of the CFC or related to such a United States shareholder. This longstanding exception does not by its terms apply to borrowers other than corporations. AJCA 2004 filled in the gap by adding section 956(c)(2)(M), which provides an exception for an obligation of a United States person which is not a domestic corporation and is neither a United States shareholder of the CFC nor a partnership, estate or trust in which the CFC or any related person is a partner, beneficiary or trustee.

Applying these principles to a REMIC regular interest, a threshold question is whether the issuing REMIC is a United States person. It is not a corporation, partnership or trust except as otherwise provided in the REMIC rules (see section 860A(a)), and those rules have only a limited exception treating a REMIC as a partership for certain procedural purposes. See section 860F(e), discussed below in Part E.2.a. Conceivably a REMIC could be considered a domestic “resident” within the meaning of the phrase “citizen or resident.” In context, the reference seems directed at individuals, but corporations and other entities (including partnerships) are sometimes described as residents or nonresidents for purposes of the Code.333b

At any rate, even if a REMIC were considered a United States person, a REMIC regular interest should fall within the exception in section 956(c)(2)(M). It is possible (but by no means certain) that a REMIC would be considered analogous to a partnership or trust for this purpose, so the case would be harder if the CFC or a related person owned all or part of the REMIC residual interest. Further, if a REMIC were established to act as a conduit for making a loan by a CFC to a United States person related to the CFC, the risks of looking through the REMIC to the ultimate borrower under general tax law principles should be carefully considered.333c

333a Treasury Regulation § 1.956-2(a)(1)(iii). 333b See, e.g., Treasury Regulation § 1.861-2(a)(2) (“resident of the United States” includes domestic

partnerships engaged in a trade or business in the United States for purposes of the interest-sourcing rules).

333c Conduit authorities are discussed in Chapter 3, Part D.1.h (see in particular the rulings under section 956 cited in footnote 56). As discussed in Chapter 16, Part A (in this Supplement), Project Apache, one of the FASIT transactions entered into by Enron that was discussed in the JCT Enron Report, involved financing Enron receivables through a FASIT with a view to avoiding the earnings stripping rules in section 163(j). Also, the FASIT regulations included extensive anti-conduit rules, which are described in Chapter 16, Part H.3. See, e.g., Proposed Regulation § 1.860H-5 (although the proposed regulation, as drafted, applies to FASIT regular interests and

Chapter 6

87

E. REMIC Elections and Other Procedural Matters

2. Other Procedural Matters

a. General

Add the following new footnote 353a at the end of second sentence of the third paragraph on page 447:

But see Treasury Regulation § 1.860F-4(a), amended on February 25, 2005, by T.D. 9184, effective December 31, 1986, to provide that the identity of a holder of a residual interest is not treated as a “partnership item” with respect to the REMIC for purposes of subchapter C of chapter 63 (section 6221 through 6234, providing for partnership-level audits of partnership items). In English, this means that the issue of who is the residual interest holder would be resolved through audits of those who have held residual interests and not through a REMIC-level audit. This rule appears to be a backhanded way of reaching the substantive issue of whether a domestic partnership comprised of foreign partners is treated as a domestic person for purposes of Treasury Regulation § 1.860E-1(c), the rule disregarding transfers to domestic transferees if a significant purpose of the transfer was to enable the transferor to impede the assessment or collection of tax, and Treasury Regulation § 1.860G-3, the rule disregarding transfers to foreign transferees if there is tax avoidance potential. The treatment of transfers of REMIC residual interests to domestic partnerships with foreign partners led to the announcement of a settlement with two taxpayers, the Diversified Financial Corporation and AVM L.P., discussed in Chapter 9, Part E.4.e.(ii) (in this Supplement).


Section 6231(a)(1)(B) is described as an exception for “small partnerships.” Revenue Ruling 2004-88, 2004-32 I.R.B. 165, holds that a partnership having as a partner a disregarded entity owned by an individual cannot qualify for the small partnership exception because the exception does not apply to partnership interests held through a pass-thru partner, including a disregarded entity that is recognized to be a state law partner. The same reasoning may well apply to a REMIC residual interest held through a disregarded entity. The ruling also confirms that the disregarded entity may be a tax matters partner even though it is not recognized as an entity for substantive tax purposes.

does not apply to REMICs, the related preamble requested comments concerning whether FASIT regular interests, REMIC regular interests, and pass-through certificates should be treated in a consistent manner for purposes of applying U.S. withholding tax rules). As the FASIT provisions of the Code have been repealed, it is highly unlikely that Proposed Regulation § 1.860H-5 will ever be issued as a final regulation; however, it may provide some insight into what the Service might find abusive in the REMIC context. See also Treasury Regulation § 1.163-5T (a REMIC anti-abuse rule directed at attempts to avoid the TEFRA debt registration requirements).

88

Chapter 7 Definition of REMIC Regular Interest

B. Fixed Terms

For a discussion of how to apply the fixed terms requirement where REMIC regular interests are issued by a REMIC at different times over a 10-day period, see Chapter 6, Part B (in this Supplement).

C. Permitted Interest Rates

4. Specified Portions

The NYSBA Reforms Report proposes an overhaul of the definition of specified portion that would generally eliminate the need to use two tiers of REMICs to create interest strip classes.

b. Interest Payments

The text at footnotes 96 and 97 discusses how to apply the specified portion rules to a qualified mortgage where the interest that is required to be paid on the mortgage during a period is less than the interest that accrues. The approach taken in the private letter ruling discussed in footnote 97, which treats the interest accruing as the interest payable, makes a good deal of sense. The REMIC regular interest definition is based more on entitlements than cash payments, as evidenced by the rule in Treasury Regulation § 1.860G-1(b)(3)(iv) that allows interest on a regular interest (including a specified portion regular interest) to be deferred without jeopardizing the status of the class as a regular interest. Accordingly, whether a share of interest qualifies as a specified portion should be determined without regard to when the interest that is carved up is paid.

D. Contingencies

AJCA 2004 amended section 860G(a)(1) to provide that an interest will not fail to qualify as a regular interest solely because the specified principal amount (or interest accrued) can be reduced as a result of the nonoccurrence of 1 or more contingent payments with respect to any reverse mortgage loan held by the REMIC if, on the startup day, the sponsor reasonably believes that all principal and interest due under the regular interest will be paid at or prior to the liquidation of the REMIC. For a discussion of the package of AJCA 2004 amendments to section 860G adopted to allow a REMIC to hold reverse mortgage loans (including the definition of reverse mortgage loan and further information on the new contingency rule), see Chapter 6, Part B.2.a.(v) (in this Supplement).

89

Chapter 8 Taxation of Holders of Asset-Backed Securities Taxable as Debt

A. Introduction


In addition, the IRS has proposed special rules for determining accrual periods for REMIC regular interests to address payment lags. They are described in Part H.5, below (in this Supplement).

C. Original Issue Discount

1. OID Defined


In a typical securitization transaction, the issuer is required to make payments on asset-backed securities out of available cash flows according to a payment waterfall. If funds are not sufficient to make timely payments due to defaults or delinquencies on underlying receivables, there is typically not a default in so many words on the securities (although the holders of affected classes may be given rights to direct or approve actions of the issuer or servicer). For such securities, it would make sense to conclude that interest is “unconditionally payable” by the issuer on a given date if the interest would be payable on that date absent defaults on receivables held by the issuer (in other words, the only payment contingencies relate to payment defaults on the underlying receivables). This conclusion could be reached under the regulations in a straightforward way with respect to a class of asset-backed securities if the likelihood of a payment shortfall is remote. If that is not the case, then the same result could be reached by arguing that (1) the reference to legal remedies that exist to compel payment encompasses both the remedies available to securities holders to compel payment by the issuer and remedies available to the issuer to compel payment on the underlying receivables, (2) the kind of “default” that is disregarded includes a default on underlying receivables, or (3) for a securitization vehicle the financial health of which depends directly on the payments it receives, a default in payments due to the vehicle is a “similar circumstance” to default or insolvency by or of the vehicle. Cf. T.A.M. 200448047 (August 30, 2004).

Add the following at the end of the text accompanying footnote 27 on page 528:

Concluding that interest is not qualified stated interest (and is therefore includible in OID) is likely to have little practical effect on taxpayers using an accrual method for tax purposes (which include all holders of REMIC regular interests with respect to their REMIC regular interests) since they would include stated interest in income as it accrues even if it were not OID.

Chapter 8

90

2. Debt Instruments Subject to the PAC Method

Add the following footnote 33a at the end of the second full paragraph on page 531:

P.L.R. 200347016 (November 26, 2002) involves a securitization program in which debt instruments were secured by an interest in a revolving pool of credit card receivables. Principal payments received on the credit card receivables were required to be applied to purchase new receivables under a contract with the credit card issuer so as to maintain a constant principal balance of receivables, but principal payments received on the credit card receivables could be applied to prepay principal on the issued debt in certain circumstances. The IRS concluded that the possibility of prepayments would be ignored (so that section 1272(a)(6) would not apply) because prepayments would occur only in the event of a default or insolvency of the credit card issuer or in other circumstances that were considered to be remote. The ruling notes that remote contingencies and default and similar contingencies are generally ignored for purposes of the OID provisions. See footnote 46, below.

3. OID Accruals for Debt Instruments Generally


Offsetting OID with acquisition premium is mandatory. By contrast, as discussed in Part F, below, premium amortization is elective.


Treasury Regulation § 1.988-6 extends the principles of the CPDI rules to contingent payment debt instruments for which one or more payments are denominated in, or determined by reference to, a nonfunctional currency, applicable to debt instruments issued on or after October 29, 2004. Previously, such instruments were excepted from the application of the CPDI rules. A nonfunctional currency borrowing is not considered contingent merely because it is denominated in a single nonfunctional currency (even though payments would not be fixed in the functional currency). The regulations consider contingencies that exist because payments are denominated in more than one currency or because of contingencies unrelated to currencies.

4. OID Accruals Under the PAC Method

Section 433(b)(10) of the Senate JOBS Bill in the form in which it passed the Senate Finance Committee on October 1, 2003 would have amended section 1272(a)(6)(B) to require the IRS to prescribe regulations permitting the use of a current Prepayment Assumption, determined as of the close of the accrual period (or such other time as the IRS may prescribe during the taxable year in which the accrual period ends). However, the change was dropped before the bill passed the Senate.

D. Stripped Bond Rules

1. Definition of Stripped Bond or Coupon

In 2006, the IRS issued an important private letter ruling holding that floating rate and inverse floating rate interests in a fixed rate mortgage qualify as stripped coupons within the

Chapter 8

91

meaning of section 1286, provided they would qualified as specified portions of the interest payments on the mortgages under the REMIC rules if they applied. For a description of the ruling, see Chapter 3, Part D.6.a. (in this Supplement).


AJCA 2004 enacted section 1286(f), which authorizes the issuance of regulations extending application of rules similar to those of section 1286 and section 305(e) to accounts or entities, such as money market funds, substantially all of the assets of which are bonds or preferred stock (or a combination thereof), effective for purchases and dispositions after October 22, 2004. For further discussion of the new section and the stripping of equity interests generally, see Chapter 4, Part D.6.d. (in this Supplement).

2. Treatment of Stripped Bonds


If the debt instrument that is stripped pays interest at a variable rate (e.g., a margin over LIBOR), questions arise as to the proper treatment of stripped coupons representing a right to the variable interest payments (without principal). There appear to be no authorities addressing instruments of this type.93a

As discussed in Part C.3, above, debt instruments that pay interest based on a conventional interest rate index generally qualify as VRDIs, as defined in the OID regulations, and are subject to special rules found in Treasury Regulation § 1.1275-5. Those rules generally apply the OID rules by first converting the variable interest payments into equivalent fixed rate payments and then applying general OID rules to the resulting fixed rate instrument. Current adjustments are then made for the difference between the actual interest paid and the assumed fixed payments. A debt instrument that provides for variable payments that is not a VRDI is ordinarily governed by the contingent payment debt instrument (CPDI) rules in Treasury Regulation § 1.1275-4, except that they do not apply to debt instruments subject to the PAC method. The CPDI rules are also described in Part C.3, above.

The definition of VRDI in Treasury Regulation § 1.1275-5(a) requires, among other things, that the issue price of the debt instrument not exceed its noncontingent principal amount by more than the lesser of 15 percent or 1.5 percent multiplied by the number of complete years to maturity (or if the debt instrument has a weighted average maturity, 1.5 percent multiplied by the weighted average maturity). Stated differently, high-premium debt instruments cannot be VRDIs. It is not clear how the VRDI definition would apply to a stripped bond. Such a bond is considered a newly created bond for purposes of applying the OID rules, and one approach would be to treat the principal amount of the stripped bond as including only the principal payments on the whole bond included in the strip (none in the case of an interest only strip). On that basis, a 93a If a taxpayer divided up the right to interest payments on a fixed rate bond into a right to payments

based on an interest rate index and a right to all remaining interest payments, there is clearly a risk (absent further guidance from the Service) that the arrangement would be taxed as a partnership (under the Sears regulations) and not under section 1286. See Chapter 4, Part D.6.a. On the other hand, section 1286 clearly would apply to rights to a fixed percentage of the interest payments on a floating rate bond (where the variable feature is not created through the stripping transaction but is inherent in the bond).

Chapter 8

92

variable rate strip would be a CPDI and not a VRDI, unless the PAC method applied. If the PAC method applied, then absent further guidance from the Service, very likely the VRDI rules should be applied by analogy.

Alternatively, the principal amount of a stripped coupon could be measured by the principal amount of the whole (unstripped) bond. The rationale for this approach is that section 1286 treats partial interests in a bond under rules applicable to the whole bond even if those rules would not be appropriate for a stand alone instrument. For example, a right to a variable stream of payments computed by applying an interest rate index to a notional principal amount, with no floor, likely would not be a debt instrument if issued in isolation because of the lack of principal protection. However, it would be treated as a debt instrument under section 1286 if it represents a partial interest in a conventional floating rate bond.

One of the main consequences of applying the CPDI rules to a variable rate strip would be to convert any gain on sale to ordinary income. (See text accompanying footnote 61, above). Viewed as a separate instrument, such a strip resembles a prepaid notional principal contract. Gain on the sale of such a contract is considered capital gain. Thus, to the extent it is considered appropriate to evaluate the instrument as a stand-alone instrument, capital gain treatment may be thought to be appropriate based on the NPC analogy. Also, variable rate strips resemble REMIC regular interests created under the specified portion rules, which also are not taxed under the CPDI rules. See Chapter 7, Part C.4.

F. Premium

3. PAC Method


In P.L.R. 200152028 (September 28, 2001), the Service held, without discussion of the TRA 1986 legislative history, that section 171(b)(1)(B)(ii)’s requirement that call options be taken into account in amortizing premium only if they reduce the rate of amortization requires that a zero prepayment assumption be used in amortizing bond premium on REMIC regular interests. The authors continue to believe that the pricing prepayment assumption should be used to reflect prepayments on a regular interest caused by prepayments on the underlying mortgages and that section 171(b)(1)(B)(ii) applies only to optional calls.

G. Special Considerations for Pass-Through Certificates and Other Pools

2. OID in Residential Mortgages and Other Consumer Loans


There has been uncertainty regarding the treatment as interest or other income of annual fees, late fees and other penalties charged to credit card holders by card issuers. The IRS has recently issued rulings and revenue procedures addressing some of these issues.157a The IRS has 157a Revenue Ruling 2004-52, 2004-22 I.R.B. 973, addresses the treatment of credit card annual fees.

The annual fee is charged without regard to whether the card holder uses the card and entitles the holder to various benefits and services. The fees may be charged at one time and be nonrefundable or be subject to rebate if the account is closed during the year. The ruling holds

Chapter 8

93

also issued a ruling and revenue procedure addressing the treatment of third party and direct ATM surcharge fees for cash advances.157b

3. Application of PAC Method

a. Overview

Add the following at the end of footnote 158: Section 163(h)(3)(E) allows individuals to deduct payments for insurance premiums related to acquisition indebtedness for a qualified residence by treating such insurance premiums as qualified residence interest. The section applies to premiums paid or accrued in years from 2007 through the end of 2010 on contracts issued on or after January 1, 2007 (the sunset date was extended three years by the Mortgage Forgiveness Debt Relief Act of 2007 (PL 110-142, 2007 HR 3648), enacted on December 20, 2007). In Notice 2008-15, 2008-4 I.R.B. 313, the IRS issued guidance on the allocation of prepaid mortgage insurance premiums, which must be capitalized under section 163(h)(4)(F). The notice provides that a taxpayer may allocate prepaid premium ratably over the shorter period of (i) the stated term of the mortgage or (ii) 84 months, beginning with the month in which the insurance was obtained for purposes of determining the amount treated as deductible qualified residence interest under section 163(h)(3)(E). The notice also requires an entity that receives premiums of $600 or more from a taxpayer in 2007 to file a

that the fees are income other than interest that is includible in income as they become due and payable under the terms of the credit card agreement. Notwithstanding the holding of the ruling, Revenue Procedure 2004-32, 2004-22 I.R.B. 988, allows a credit card issuer to account for annual fee income ratably over the period to which the fee relates (with the unrefunded balance of the fee for any account being included in income when the account is closed) and grants consent to taxpayers to change their method of accounting for annual fee income to either the ratable method or the method described in Revenue Ruling 2004-52. Revenue Procedure 2004-33, 2004-22 I.R.B. 989, allows credit card issuers meeting certain requirements to treat late fees as interest income, or as OID. The Revenue Procedure also states that the IRS will not challenge the treatment of late fees as OID for taxable years ending before (not on or before) December 31, 2003. The concession does not extend to the method of accounting for OID income (including whether a taxpayer is properly accounting for OID in accordance with the PAC method discussed below in Part G.3). Apparently, a number of taxpayers have taken the view that late fees on credit card receivables may be treated as OID and spread over the remaining life of the receivables under the PAC method. Revenue Ruling 2007-1, 2007-3 I.R.B. 265, holds that a fee charged by a credit card issuer to a card holder who writes an account check that is not honored because it would cause the card holder to become overdrawn is not interest. The fee must be included in income when the account check is presented.

157b Revenue Ruling 2005-47, 2005-32 I.R.B. 261, treats surcharge fees charged by an ATM owner that is not the card issuer to a card holder for obtaining a cash advances from an ATM as additional amounts loaned to the card holder by the card issuer and a fee paid by the card holder to the ATM owner for federal income tax purposes, regardless of whether the amount is reflected on the card holder’s account as part of the amount of the cash advance or as a separately stated amount. In Revenue Procedure 2005-47, 2005-32 I.R.B. 261, the IRS agrees to allow taxpayers meeting the requirements of the revenue procedure to treat fees they charge for cash advances as creating or increasing OID accounted for under the PAC method and grants consent to change to that method of accounting for those fees. The revenue procedure requires that the fees be separately stated on the card holder’s account and, under the credit card agreement, not be charged for property or specified services performed by the taxpayer for the benefit of the card holder.

Chapter 8

94

Form 1098. The reporting entity is required to determine the amount allocable to 2007 in accordance with guidance in the notice (i.e., allocated over 84 months or the term of the loan). An entity that reports either the amount actually received or the amount determined under the 84 month allocation will be deemed to meet the reasonable cause exception for failing to file a correct return under section 6724(a). The Mortgage Bankers Association and other industry members have requested changes in the notice to accommodate current software limitations which generally allow reporting based on premium disbursements rather than accruals. See letter to the IRS from Stephen A. O’Connor, March 28, 2008, 2008 Tax Notes Today 68-27.


The 2008-2009 IRS Business Plan reinstates “[g]uidance under section 1272(a)(6) with respect to the accrual of original issue discount (OID) on pools of revolving cardholder debt held by credit card issuers” as a project the IRS expects to complete in the plan year ending June 30, 2009. A similar item had been listed in the 2001 IRS Business Plan but had been dropped in subsequent business plans.

See Part G.2, above, footnote 157a and accompanying text (in this Supplement) for a description of various guidance issued by the IRS on the treatment of annual fees, late fees and other penalties charged by credit card issuers. The Service takes the view that late fees may be treated as OID, but leaves open the question of how to account for the OID under the PAC method.

b. Existence of a “Pool”


On December 31, 2003, the IRS issued final regulations addressing the capitalization of amounts paid to acquire or create intangibles. The regulations do not require capitalization of certain de minimis costs or amounts paid to create certain short-term rights or benefits, and permit taxpayers to establish pooling methods for similar items in applying the tests. See Treasury Regulation § 1.263(a)-4(d)(6)(v) (de minimis contract rights), (e)(4)(iii)(A) (de minimis transaction costs) and (f)(5)(iii) (12-month rule for renewable rights). Under those methods, amounts relating to a pool are allocated pro rata to the transactions in the pool to determine if the costs are de minimis or the extent to which the 12-month rule will apply. The regulations provide that a taxpayer may utilize the pooling methods only if the taxpayer reasonably expects to engage in at least 25 similar transactions during the taxable year and provide rules for determining how pools should be defined. See Treasury Regulation § 1.263(a)-4(h) and the sections referred to therein.


Final regulations implementing the new reporting regime have been adopted and are described in Chapter 14, Part C (in this supplement).

Delete footnote 171.


Final regulations implementing the new reporting regime have been adopted and are described in Chapter 14, Part C (in this supplement).

Chapter 8

95

c. Other Implementation Issues.

Delete the word “while” from the last sentence beginning on page 589.

4. Simplifying Conventions

Final (and some temporary and proposed) information reporting regulations for widely held fixed investment trusts (WHFITs) were issued in 2006. They permit an aggregation approach, for reporting purposes, for some, but not all, WHFITs. See Chapter 14, Part C (in this supplement)

H. Special Topics

Delete “and” before “(4)” in the carryover paragraph on 594 and 595 and add the following at the end of the paragraph:

, and (5) the treatment of payment lags for REMIC regular interests.

1. Prepayment Losses Attributable to IO Interests

Add the following new section H.1.f at the end of Part H.1:

f. Announcement 2004-75. In August 2004, the IRS issued a thoughtful announcement describing and requesting comments on proposed regulations to be issued addressing the tax treatment of IO Interests (see Announcement 2004-75, 2004-40 I.R.B. 580, which is a reissuance in October of the August announcement). The announcement adopts much of the reasoning set forth in Part H.1 and endorses with some qualifications the allowance of a deduction for negative OID on IO Interests.

The announcement provides background information on the tax treatment of IO Interests. The discussion refers to uncertainties about whether the excess of the amount paid for an IO over its actual principal amount may be treated as bond premium. There is a brief and diplomatic summary of Glick which makes no comment on whether its holding is right or wrong. The announcement refers to the statement in the 1986 legislative history providing that OID calculated under the PAC method cannot be negative and explains that it was made at a time when IO Interests were not allowed. For a conventional discount instrument, negative OID occurs when prepayments are slower than expected, and the negative amounts will eventually be reversed. In contrast, for IO Interests, negative OID results from faster than expected prepayments that may represent a true economic loss. A ban on deducting negative OID may overstate the IO Interest holder’s income and understate the income of the issuing REMIC. The announcement describes methods for accruing market discount and notes distortions that can arise when market discount on an IO Interest is accrued in proportion to OID accruals and OID amounts are zero (because of the zero floor on OID accruals).

The announcement indicates that a new method for computing income on IO Interests might apply not only to REMIC regular interests but also to stripped bonds or coupons, all REMIC regular interests issued with high premium and to similar non-REMIC debt instruments.

The announcement also indicates that the IRS is considering issuing regulations that would allow deductions to holders for negative OID computed under the PAC method (with

Chapter 8

96

corresponding income inclusions for the REMIC). The PAC method is specifically designed to deal with debt instruments subject to prepayment, and Congress did not have IO Interests in mind in making the statement about negative OID in the 1986 legislative history.

The announcement indicates that special adjustments may be required for secondary market purchasers to account for the fact that they may buy at a significant discount reflecting not only changes in market interest rates but also the prepayment history and changed expectations about future prepayments. For example, negative OID deductions for a secondary market purchaser might be limited to prior income inclusions.

The announcement also asks whether prepayment losses could appropriately be dealt with through regulations under section 166 (bad debts). Finally, it outlines an alternative method for computing income on an IO Interest that is essentially an income forecast method. Payments received in a period would be offset with a portion of basis equal to the payments received in the period divided by total expected payments.

Announcement 2004-75 represents real progress. Specifically, it acknowledges that it may well be appropriate to allow deductions for negative OID computed under the PAC method (as a premium deduction or on some other theory) in cases where the deduction does not reduce basis to below the principal amount. Specifically, the IRS does not believe the 1986 legislative history to be controlling for IO Interests. Further, the announcement acknowledges the government victory in Glick but then disavows it by offering several alternatives that would permit deductions for negative amounts.

Hopefully the IRS will follow through and adopt regulations allowing income to be computed under the PAC method with no limit on deductions for negative amounts. There likely should be a special regime for market discount instruments requiring the computation of PAC accruals to be based on the purchaser’s yield or on a revised prepayment assumption that will produce the original yield using the investor’s purchase price as the adjusted issue price.

The New York State Bar Association Tax Section has submitted a report in response to the announcement. See “Report on REMIC IO Interests,” (January 31, 2005) (in 2005 Tax Notes Today 22-13 (February 3, 2005)). The report endorses the allowance of a bond premium deduction for negative amounts computed under the PAC method (as long as the deduction does not reduce basis below the principal amount) and recommends an adjustment to the yield or prepayment assumption used in computing PAC accruals for secondary market purchasers that buy at a discount. The report waffles on whether premium deductions should be limited to prior income inclusions, although in the view of the authors of this book, the reasons given in the report for allowing an unlimited deduction are significantly stronger than the reasons against it, particularly if the PAC method is adjusted for secondary market purchasers as recommended in the report. Those reasons include avoiding an understatement of income of the REMIC and achieving parity with the treatment of PO interests (discount inclusions by PO interest holders from greater than expected prepayments would not be capped).

In practical terms, the announcement is likely to make it far easier for taxpayers to claim deductions for negative OID for periods before regulations are issued. It is worth noting that the adoption of regulations permitting deductions for negative OID will almost undoubtedly require REMICs (and, therefore, REMIC residual interest holders) to accrue corresponding amounts as cancellation of indebtedness income, exacerbating the phantom income issue for REMIC residual interest holders.

Chapter 8

97

The 2005-2006 IRS Business Plan had included “[g]uidance regarding the application of OID accruals and writedowns for interest-only REMIC regular interests.” However, this item has not been included in subsequent business plans. The 2004-2005 IRS Business Plan had included “[g]uidance on interest-only REMIC regular interests.”

2. Delinquencies and Defaults


The 2008-2009 IRS Business Plan lists “[g]uidance relating to the accrual of interest on distressed debt” as a project the IRS expects to complete in the plan year ending June 30, 2009. This project was not included in the 2007-2008 IRS Business Plan. However, the 2006-2007 IRS Business Plan included “[g]uidance addressing the accrual of interest on nonperforming loans.” Hopefully, the treatment of OID is one topic that the guidance would address. For an interesting report outlining current problem areas including the treatment of OID, see “Report Regarding Proposals for Accounting Treatment of Interest on Non-performing Loans,” by New York City Bar, Committee on Taxation of Business Entities, July 23, 2008, 2008 Tax Notes Today 145-59. The New York State Bar Association, Tax Section, has also weighed in on the tax issues of interest to debtors and creditors in the current troubled times. See letter from David S. Miller, August 19, 2008, 2008 Tax Notes Today 162-14.


For a discussion of current applications of the conformity rule (which include some arbitrary periods of delinquency for beginning charge offs), see Revenue Ruling 2001-59, 2001-51 I.R.B. 585. A recent ruling clarifies that the accrual of interest income for federal income tax purposes may diverge from accrual for regulatory purposes. Revenue Ruling 2007-32, 2007-21 I.R.B. 1278, distinguishing Revenue Ruling 81-18, generally requires banks using the accrual method to include in gross income accrued interest in the taxable year in which the right to receive the interest becomes fixed, notwithstanding that accrual of such amounts may have been suspended for federal regulatory purposes. See Treasury Regulation §§ 1.446-2(a)(1) and 1.451-1(a). Federal banking rules generally require banks to suspend recognition of accrued interest for regulatory financial statement purposes on loans that show certain signs of credit deterioration. For federal income tax purposes, however, unless it can be demonstrated that there is no reasonable expectation of payment, a mere delinquency in payments does not suspend the accrual of interest income. The bank should adjust for accrued interest that is not collected by claiming a bad debt deduction under section 166 or a deduction for increases in a reserve for bad debts under section 585 available to certain banks. A bank that uses the conformity method of accounting for bad debts (described in footnote 217 below) can claim a bad debt deduction for accrued interest that is written off and through that indirect means effectively stop accruing interest for federal income tax purposes if it has stopped accruing such interest for regulatory purposes. See also Chapter 11, Part B. Further, while amounts collected in respect of certain delinquent loans generally are applied as payments of principal under federal banking regulations, banks generally are required to treat such amounts as interest under Treasury Regulation § 1.446-2(e) for federal income tax purposes to the extent there is uncollected accrued interest. Revenue Procedure 2007-33, 2007-21 I.R.B. 1289, allows banks to change their method of accounting for unpaid interest to a method that determines the amount reasonably expected to be collected on a pool basis based on an historical recovery percentage.


Chapter 8

98

Revenue Ruling 2007-32, 2007-21 I.R.B. 1278, provides that banks using the conformity method of accounting under Treasury Regulation § 1.166-2(d) can deduct accrued interest previously included in gross income, in the year such amount is charged off for federal regulatory purposes.

T.A.M. 200814026 (April 4, 2008) considers the circumstances in which a taxpayer, in its capacity as guarantor, is entitled to a bad debt deduction and the timing of such deduction. The memorandum rejects a taxpayer’s attempt to accelerate a bad debt deduction for payments on notes issued by a trust, of which it was the sole owner. Treasury Regulation § 1.166-9(a) generally allows a bad debt deduction for payments made by a taxpayer in its capacity as guarantor or secondary obligor on debt it guaranteed in the year payments are made. In this case, the taxpayer was not allowed a bad debt deduction for purported payments in respect of certain notes, in its capacity as a guarantor. Through a complicated series of transactions, the taxpayer acquired notes issued by a grantor trust, then subsequently acquired all beneficial ownership interests in the trust. The taxpayer then undertook obligations to make payments to the trust’s trustee to fund an optional redemption of the notes and thereafter made payments to the trustee to redeem the notes. The IRS ruled that, as the owner of the trust, the taxpayer is treated as both the obligor and holder of the note. Thus, payments to the trustee, which were then used to redeem the notes held by the taxpayer, were disregarded and not given effect for purposes of recognizing a bad debt deduction under Treasury Regulation § 1.166-9(a).

The IRS further ruled that the taxpayer was not entitled to a bad debt deduction for payments to the trustee to redeem the notes because it was not legally bound to make payments to redeem the notes (a necessary element for a bad debt deduction). The taxpayer acquired the trust notes in exchange for its own notes, which were issued to the original holders of the trust notes. The IRS viewed the substituted notes as a guaranty made by the taxpayer in favor of the original holders of the trust notes. Relying on settled case law, the IRS noted that a taxpayer that substitutes its own debt for debt it guaranteed generally is allowed a bad deduction for amounts actually paid on the substituted debt. The issuance of a note, in itself, however, does not constitute payment on the debt. Thus, the taxpayer would be allowed a bad debt deduction only when it redeems its own substituted notes. The taxpayer argued, unsuccessfully, that the substituted note rule was inapplicable because it was not a guarantor of the trust notes since its obligations were to the trust, rather than to the original holders of the notes. Instead, the taxpayer’s obligations to the trust merely constituted credit support or a keep well agreement. The IRS rejected this distinction and viewed the substance of the transactions as an obligation of the taxpayer to the holders, despite the lack of contractual privity between them.

3. Securities Representing a Debt Instrument Combined with Another Financial Contract

a. NPCs

Add the following at the end of Part H.3.a:

As discussed in Chapter 2, Part H (in this Supplement), CBOs are sometimes issued in synthetic form or are backed by synthetic collateral. These arrangements involve the use of a

Chapter 8

99

default swap (or a PAYGO swap)237a under which the protection purchaser makes periodic payments in exchange for shifting credit risk to the protection seller. There is some uncertainty under current law whether default swaps and PAYGO swaps should be viewed as notional principal contracts.237b Assuming, however, that the NPC rules apply, it appears likely under current law (disregarding the proposed contingent payment swap regulations described below) that a noncontingent payment on a default or PAYGO swap would be subject to the regular NPC rules (i.e., generally included in income or deducted when accrued) and a payment contingent on a credit event or default or delinquency would be included in income or deducted only when the contingent payment is made (or possibly becomes fixed and determinable, if fixed and determinable before payment). This method of accounting for contingent payments is often referred to as the wait-and-see or open transaction method of accounting.237c

On February 25, 2004, the Service published proposed regulations addressing the treatment of NPCs that provide for contingent nonperiodic payments (CNPCs).237d The regulations were aimed mostly at equity swaps, but by their terms apply broadly to all types of NPCs. The CNPC proposed regulations prohibit the use of the wait-and-see method of accounting for contingent nonperiodic payments. Instead, a taxpayer, regardless of its method of accounting, must recognize contingent nonperiodic payments under the so-called noncontingent swap method, or

237a The terms of a typical PAYGO swap are summarized in Chapter 2, Part H and in the Glossary (in

this Supplement). 237b Most tax practitioners think they should be viewed as notional principal contracts, but

characterization as put options cannot be entirely ruled out. For a discussion of the tax treatment of credit derivatives generally, see Bruce E. Kayle, “The Federal Income Tax Treatment of Credit Derivative Transactions,” Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2001 (P.L.I. 2001), vol. 15, 913; David Z. Nirenberg and Steven L. Kopp, “U.S. Federal Income Tax Consequences of Credit Derivative Transaction,” Chapter 13, Credit Derivatives−Applications for Risk Management, Investment and Portfolio Optimization (Risk Books 1998).

237c For one statement confirming this view, see New York State Bar Association, Tax Section, “Report on Notional Principal Contract Character and Timing Issues,” 79 Tax Notes 1303 (June 8, 1998) (“The Committee believes that, under current law, gain or loss with respect to a contingent nonperiodic payment is deferred until it is fixed under the wait-and-see approach.”).

237d See 2004-13 I.R.B. 655. The IRS had previously announced in Notice 2001-44, 2001-2 C.B. 77, that it was soliciting comments on the appropriate method of accounting for income and deductions for CNPCs. The Notice set out four different methods under consideration by the IRS, each of which was different from current law. The proposed methods were: (1) the Noncontingent Swap Method, (2) the Full Allocation Method, (3) the Modified Full Allocation Method, and (4) the Mark-to-Market Method. In very general terms: (1) under the Noncontingent Swap Method, a contingent payment is required to be included in income over the life of the CNPC by replacing the contingent payment with a hypothetical noncontingent payment, and then recognizing income or deductions with respect to the hypothetical noncontingent payment on a constant yield basis; (2) under the Full Allocation Method, no income or deductions are recognized until all contingencies are resolved; (3) under the Modified Full Allocation Method, each year payments made and received are netted and any net positive number is included in income, but deductions for net negative numbers are deferred until all contingencies are resolved; and (4) under the Mark-to-Market Method, CNPCs are marked to market each year. The noncontingent swap method in the CNPC proposed regulations (described in the text below) is not the same as the noncontingent swap method described in Notice 2001-44; rather, it is a hybrid between that method and a mark-to-market method.

Chapter 8

100

alternatively in some cases an elective mark-to-market method.237e The noncontingent swap method is described in more detail below.

The noncontingent swap method requires the taxpayer to determine, as described below, the projected amount of each contingent nonperiodic payment. The taxpayer then amortizes that projected amount over the life of the swap as if it were a fixed nonperiodic payment. Projected amounts payable by one swap party that are “significant” compared to other payments made by that same party are taken into account as if they were payments on a level payment loan bearing interest at the AFR. The payments on that loan are considered to be offset with swap payments and the interest components of the payments are recognized to be interest. For example, if one party is required to make a significant payment at the end of the swap, it would be deemed to make level payments treated as swap payments over the life of the swap, and then (since it will not actually make those periodic payments), to borrow corresponding amounts which it then repays with interest through the payment at the end, The calculations must be done on the commencement date of the NPC and then on each successive anniversary of the commencement date (each, a redetermination date). The taxpayer then makes adjustments to reflect the new numbers for periods following a redetermination date.237f

Specifically, on a redetermination date, the taxpayer must re-estimate the projected amount and reapply the level payment method as of the commencement date (that is, going back to when the swap started) on the basis of the new projected amount and the AFR in effect on the redetermination date. The new schedule must be used for accruals during the current taxable year and all subsequent years. Any difference between the amounts that would have been recognized in prior taxable years under the new schedule and the amounts actually recognized in those years is taken into account ratably over the one-year period beginning with the redetermination date as if it were a payment or receipt on the CNPC except that, to the extent of the difference in interest payments, the adjustment is recognized as interest for all purposes of the Code. In the taxable year in which the contingent payment is made or received, the net income or deduction with respect to the CNPC is adjusted to reflect any difference between the cumulative amount previously recognized based on the projected amount and the actual payment.

237e Proposed Regulation § 1.446-3(g)(6). Proposed Regulation § 1.446-3(i) allows a taxpayer to elect

to account for all NPCs that provide for nonperiodic payments (including CNPCs) and fall into one of four categories described below under a mark-to-market method (the election once made affects all qualifying NPCs of the taxpayer). A taxpayer must still treat significant nonperiodic payments as giving rise to a deemed loan and account for interest on the loan separately from other swap income or deductions. However, the interest amounts are calculated based on significant nonperiodic payments projected when an NPC is entered into and are not adjusted thereafter. The mark-to-market election can be made for NPCs that are: (1) of a type that are actively traded (defined through a cross-reference to regulations under section 1092(d)), (2) marked to market by the taxpayer for financial statement purposes (subject to some conditions that have not yet been announced), (3) subject to an agreement by a securities dealer counterparty to supply the value it uses to mark the contract to market under section 475, or (4) marked to market by a RIC described in section 1296(e) (generally has outstanding stock that is redeemable at net asset value).

237f See Proposed Regulation § 1.446-3(g)(6)(ii), (iv) through (vi). The proposed regulations also provide for a special redetermination date when a contingent payment becomes fixed more than six months before it is due in a taxable year different than the taxable year in which it is due. See Proposed Regulation § 1.446-3(g)(6)(iv)(B).

Chapter 8

101

The noncontingent swap method is a quasi-mark-to-market system, but the calculations are more complex. Also, the annual redetermination adjustments are not all taken into account currently but rather are spread over the remaining term of the CNPC to the extent attributable to future periods or over one year to the extent attributable to the past. The portion of the total adjustment that is taken into account within a year is based on the portion of the entire term of the swap that has elapsed as of redetermination date, and accordingly increases over time.

Under the proposed regulations, the projected amount of a contingent nonperiodic payment is the reasonably expected amount of the payment.237g If a contingent nonperiodic payment is determined by reference to the value of a specified index on a designated future date, the projected amount is determined as follows:

• if there are actively traded futures or forward contracts on the index providing for delivery or settlement on a date that is the same as or within 3 months of the designated future date, the projected amount is the future value of the index as determined under those contracts (using the contract with the same delivery or settlement date if available); or|

• if the current value of the index is established by objective financial information, the projected amount is the current value converted to the future value on the designated future date by adding interest accrued on a constant yield basis at the AFR and adjusting for payments (such as dividends) expected to be made on the property underlying the index; or

• if neither of the two previous methods results in a reasonable estimate of the expected amount of the contingent payment, the taxpayer must determine the projected amount using another method based on objective financial information that does result in a reasonable estimate. Under the proposed regulations, all periodic and nonperiodic payments made or deemed

made under an NPC (including CNPCs) are considered to be ordinary income or deductions, even if the payment amounts depend on the value of property that would be a capital asset in the hands of the taxpayer. Specifically, income and deductions are not capital gains or losses unless they arise from the sale or exchange of property, and swap payments are not considered to be from a sale or exchange unless they result from an assignment, or from a cancellation of a swap that is treated as a sale or exchange under section 1234A. The proposed regulations make it clear that the only swap payments that result in a section 1234A sale or exchange are termination payments (payments from an assignment or negotiated early termination). Thus, scheduled payments (including nonperiodic payments made at maturity of a swap) result in ordinary income or deductions.237h

By their terms, the proposed regulations are proposed to be effective only for CNPCs entered into on or after 30 days after final regulations are issued. However, the preamble to the regulations states that with respect to CNPCs entered into or in effect on or after March 27, 2004 (the “in effect” language of course encompasses continuing contracts entered into before the 237g See Proposed Regulation §§ 1.446-3(g)(6)(ii) and 1.446-3(g)(6)(iii)(A)-(C) (sets out the three

methods described below in the text). 237h See Proposed Regulation §§ 1.162-30, 1.212-1(q), and 1.1234A-1. For this purpose, gains and

losses from marking a swap to market are treated the same as scheduled swap payments (produce ordinary treatment).

Chapter 8

102

proposed regulations were issued), taxpayers that have not yet adopted an accounting method for nonperiodic contingent payments on CNPCs must adopt a method that spreads those payments over the term of the swaps rather than following the wait-and-see method.237i

As indicated above, the proposed regulations were written mostly with equity swaps in mind, and do not include any specific guidance on how they would be applied to a default swap. Often the parties expect that there will be no credit event triggering a payment, and on that basis it can be argued that the projected amount of loss-related payments should be zero.237j On the other hand, using a zero value would lead to results substantially similar to the wait-and-see approach rejected by the Service, and the parties obviously assume there is some nontrivial risk of a future loss or they would not have entered into the contract. A New York State Bar Association, Tax Section report on the CNPC regulations recommends that default swaps continue to be taxed under a wait-and-see method, at least to the extent they hedge debt or other fixed income portfolios.237k

In a letter to the IRS dated October 13, 2004, commenting on the proposed regulations, the International Swap and Derivatives Association (ISDA) recommended (1) retaining the “wait-and-see method” for CNPCs generally, and in any event for CNPCs with terms of five years or less and for longer-dated CNPCs with contingent payments that are indeterminable as to both timing and amount when entered into (e.g., credit default swaps) and (2) adopting the full allocation method, under which all income and deductions are deferred until the contingent payment is made, for other CNPCs. ISDA also recommended, inter alia, that taxpayers be

237i The preamble includes the following:

With respect to NPCs that provide for contingent nonperiodic payments and that are in effect or entered into on or after 30 days after the date of publication of these proposed regulations in the Federal Register [the 30th day was March 27, 2004], if a taxpayer has not adopted a method of accounting for these NPCs, the taxpayer must adopt a method that takes contingent nonperiodic payments into account over the life of the contract under a reasonable amortization method, which may be, but need not be, a method that satisfies the specific rules in these proposed regulations. If a taxpayer has adopted a method of accounting for these NPCs, the Commissioner generally will not require a change in the accounting method earlier than the first year ending on or after 30 days after the date of publication of the final regulations in the Federal Register. The preceding sentence does not apply to transactions described in Rev. Rul. 2002-30 (2002-1 C.B. 971) [swap with a nonperiodic payment equal to a noncontingent amount plus or minus a contingent amount; ruling requires separate treatment of contingent and noncontingent components, resulting in accrual with respect to the noncontingent amount] or other published guidance.

Note that this language leaves open the possibility that even with respect to taxpayers that have adopted a method of accounting for CNPCs, the IRS will require a change in accounting for swaps in existence on March 27, 2004 beginning in the first taxable year ending at least 30 days after the year in which final regulations are issued. Given that the proposed regulations have been quite controversial, it is very likely that final regulations will not be issued before the end of 2004.

237j Proposed Regulation § 1.446-3(g)(6)(ii) provides that “[t]he projected amount of a contingent nonperiodic payment is the reasonably expected amount of the payment…” which, under Proposed Regulation § 1.446-3(g)(6)(iii)(C), must be a “reasonable estimate of the amount of the contingent payment” and be “based on objective financial information.”

237k New York State Bar Association, Tax Section, “Report on Proposed Notional Principal Contract Regulations,” Report No. 1062, June 4, 2004, available at http://www.nysba.org/taxreports.

Chapter 8

103

permitted to elect to mark to market their CNPCs along with any positions that hedge or are hedged (in the general sense and not as defined by Treasury Regulation § 1.1221-2) by a CNPC that is marked to market and contemporaneously identified as such, regardless of the term of the CNPC.

In Notice 2004-52, 2004-32 I.R.B. 168, the IRS indicated that it had received requests for guidance regarding various issues relating to the taxation of default swaps and that it was thoroughly analyzing all of the tax issues raised by such swaps and expected to issue guidance. The notice further provided that the IRS needed more information to respond to such requests and solicited comments regarding certain economic and business terms typical in the default swap market, as well as the accounting and regulatory treatment of these contracts. It also noted that possible analogies for a default swap include derivative financial instruments such as a contingent option or notional principal contract, a financial guarantee or a standby letters of credit, and an insurance contract, and that “the economic similarity of a default swap to various financial transactions tends to blur the distinctions between possible analogies and that the various analogies correspond to significantly different tax treatment.”

The 2008-2009 IRS Business Plan includes “[r]egulations under § 446 on notional principal contracts (NPC) relating to the inclusion in income or deduction of a contingent nonperiodic payment and guidance relating to the character of payments made pursuant to an NPC” as a project the Service expects to complete in the plan year ending June 2009. The 2007-2008, 2006-2007 and 2005-2006 IRS Business Plans included the same item. The 2004-2005 IRS Business Plan had included “[f]inal regulations on notional principal contracts.”

b. Call Options

Add the following sentence to the text after the reference to footnote 240:

Special considerations apply to banks.241a

c. Other Consequences of Separate Treatment


241a Section 1234 states that gain or loss from an option “shall be considered gain or loss from the sale

or exchange of property which has the same character as the property to which the option relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).” Debt instruments held by banks may be capital assets in their hands, but gains or losses from sales or other dispositions of debt instruments are considered ordinary under section 582(c) (because a disposition is not considered a “sale or exchange”). This section is discussed in Chapter 11, Part E. It would be consistent with the policy of the section to treat gains and losses realized by a bank from an option on debt instruments as ordinary. Section 582(c) has been read to override other sections that treat gains or losses as arising from the sale or exchange of property. See Treasury Regulation § 1.582-1(d) (section 582 trumps short sale rule in section 1233) and 1.1232-3(a)(1)(iii) (overriding rule in section 1232(a)(2)(A) treating retirement of debt instrument as sale or exchange). Cf. Treasury Regulation § 1.1234-1(a)(2) (gain or loss from option on property subject to section 1231 is treated according to that section, which treats losses as ordinary and gains as capital).

Chapter 8

104

While not certain, under current law, expenses that arise from a position in a straddle should not be treated as carrying charges allocable to the straddle. Thus, periodic payments under a notional principal contract that is part of a straddle should not be subject to capitalization under section 263(g) (although payments that are treated as losses from the sale of property under section 1234A, see footnote 235, above, and accompanying text, may be subject to the loss deferral rules of section 1092). Proposed Regulation § 1.263(g)-3(b)(3), however, provides that interest or carrying charges allocable to a straddle include “[o]ther otherwise deductible payments or accruals on financial instruments that are part of a straddle or that carry part of a straddle.” Thus, if the regulation is finalized in its current form, periodic payments on a notional principal contract that is a position in a straddle (net of interest and other allowable income offsets) will be subject to capitalization under section 263(g). The regulation would be effective for payments or accruals made after final regulations are adopted for a straddle established on or after January 17, 2001. Proposed Regulation § 1.263(g)-5. In the preamble to the proposed section 263(g) regulations, the Service requested comments on whether expenses such as interest and carrying charges or payments on notional principal contracts should be included in losses deferred under section 1092. See 2000-13 I.R.B. 965, 968. This treatment could produce differences in the timing and character of the deferred amounts as compared with capitalization under section 263(g). The 2006-2007 IRS Business Plan included “[f]inal regulations under section 263(g) on the capitalization of interest and carrying changes properly allocable to straddles.” This item was also included in the 2005-2006 and 2004-2005 IRS Business Plans. However, this project was not included in business plans subsequent to the 2006-2007 IRS Business Plan.

4. Integration of Debt Instruments and Hedging Contracts

b. Qualifying Debt Instruments


P.L.R. 200347016 (November 26, 2002) holds on the particular facts of the ruling that a debt instrument that is secured by an interest in a revolving pool of credit card receivables is not subject to section 1272(a)(6) and accordingly can be integrated with an interest rate swap. For a description of the ruling, see footnote 33a, above (in this Supplement).

c. § 1.1275-6 Hedge


Chief Counsel Attorney Memorandum 2007-014 (July 16, 2007) has an interesting analysis of the integration of convertible debt with a call option purchased as a hedge. The taxpayer corporation issued convertible notes and purchased a call option from a bank to hedge the conversion feature of the notes. The hedge was exercisable automatically if the notes were converted. Taxpayer also issued a warrant to buy taxpayer’s own shares. The strike price for the warrant was higher than the strike price for the hedge and notes and there were some other differences (different settlement mechanics, and an exercise date for the warrant a few months after expiration of the hedge). The warrant did not refer to the notes and was exercisable without regard to the conversion of the notes. The taxpayer could sell the hedge without terminating the warrant, and the bank could sell the warrant without terminating the hedge. There were no offset rights for obligations under the warrant and hedge. The taxpayer sought to integrate the notes and hedge, but not the warrant. The economic effect of such integration would be that the taxpayer was

Chapter 8

105

treated as issuing nonconvertible debt at a discount (equal to the issue price of the notes less the premium paid to buy the hedge) and a separate warrant. The memorandum concludes that the taxpayer could integrate the notes and hedge without also integrating the warrant. The memorandum concludes that the warrant and hedge should be considered separate instruments in light of their different terms, separate assignability and the lack of offset rights. Further, selective integration did not violate the OID anti-abuse rule in Treasury Regulation § 1.1275-2(g), because taxpayers generally have the right to choose between issuing convertible debt or straight debt and warrants, and the transaction had the end effect of the issuance of straight debt and warrants. The memorandum states that its conclusion is limited to cases in which (1) the hedge and warrant are priced at fair market value (specifically, the parties are not inflating the two premiums in order to artificially increase the OID deductions for the integrated notes) and (2) the premium paid for the hedge is meaningfully greater than the premium received for the warrant (otherwise, it could be argued that the hedge/warrant arrangement serves no non-tax purpose). For a critical discussion of an ABA panel discussion of call spread convertibles (indicating that the government may be lulled into an impulse purchase of the taxpayer position on the subject), see Lee A. Sheppard, “Your Government at Work on New Financial Products, Part 2,” 115 Tax Notes 815 (May 28, 2007).

e. Effects of Integration

Replace footnote 255 with the following:

Treasury Regulation § 1.1275-6(d) provides rules for legging into and legging out of integrated transactions. A legging in occurs when a § 1275-6 hedge is entered into after the date when the related qualifying debt instrument was issued or acquired by the taxpayer. A legging out generally means breaking the integrated transaction by disposing of one or more of its components (the actual definition is more complicated). In brief, in a legging in transaction, the taxpayer reports income (1) from the qualifying debt instrument up through the date the § 1.1275-6 hedge is entered into and (2) from the synthetic debt instrument thereafter. There is no marking to market or acceleration of accrued market discount. The rules for legging out transactions are more complex, but generally involve realization of gain or loss as if the synthetic debt instrument were sold for its fair market value.

Add the following at the end of Part H.4.e.:

Note that if a qualifying debt instrument was acquired with market discount, that discount is not converted into OID with respect to the synthetic debt instrument, because the issue price of the synthetic instrument is based on the adjusted issue price of the qualifying debt instrument, not its tax basis in the hands of the taxpayer.

Add the following at the end of Part H:

5. Payment Lags for REMIC Regular Interests

A fixed rate REMIC regular interest typically provides for payments of interest on a specified day of the month (generally from the 15th to the 25th) that represent, according to the terms of the instrument, interest that accrued during the preceding calendar month.257a The record date for 257a By contrast, variable rate regular interests typically have accrual periods under the terms of the

instrument that end on the day before a payment date and begin on the prior payment date (or the

Chapter 8

106

receiving the interest accruing during a month is typically the last business day of the month, so that a holder is entitled to the interest for the month even if he sells immediately after month end. These contract terms are based on the fact that for residential mortgages, there is lag between the end of a calendar month for which interest is paid and the date on which interest is passed through by a mortgage servicer.

The economic effect of a payment lag is to provide a one-time interest holiday corresponding to the period from the end of the contractual interest accrual period to the payment date. The holiday represents an economic cost to investors (a period in which no interest is earned even though principal remains invested in the regular interest)

In determining the taxable income of investors and the REMIC over time, the holiday could be taken into account in one of three ways (at least): (1) by accruing interest over the entire period from the issue date of the regular interests until principal is actually repaid and then adjusting down the yield to a number that averages in the no-interest period; or by providing for an interest holiday, during which no interest accrues for tax purposes, either (2) immediately after the issue date of the instrument, or (3) at the end (for each payment of principal, the period before the principal is paid). The first choice would seem to be the right answer under current law. Interest is supposed to accrue evenly over the term of an instrument and accrual periods are normally based on payment dates.257b Further, the yield adjustment approach produces the least distortions where a regular interest changes hands because there is no period in which zero interest accrues. As to the second approach (interest holiday first), the OID regulations allow an initial interest holiday without a requirement to accrue OID under a special de minimis rule.257c The rule was intended to accommodate “teaser rates” for consumer loans. The third approach (interest holiday last) is supported by the fact that it conforms to the contractual terms of the regular interests.

None of these approaches achieves a perfect result. The first one would seem to come closest, but still is not entirely right. The reason is the convention that assumes there is on any day only one owner of a regular interest who earns all income accruing on the regular interest on that day. Economically, there can be two owners at one time as a result of the lag feature. To illustrate, suppose a regular interest provides for a payment on the 15th day of the month to the record holder on the last business day of the prior month. On June 1 (the day after the record date for the June payment), a new owner (call him X) purchases a regular interest with a remaining principal balance of $100 from the prior owner (Y). A principal payment of $50 is to be made on June 15. If X is treated as the sole owner of the regular interest after June 1 and interest accrues evenly through the payment date based on the adjusted yield, then X will be taxed on 14 days’ worth of interest on $100, even though Y (and not X) will be entitled to the $50 of principal paid on June 15. The right answer would be achieved by treating both X and Y as owners of $50 of principal for the first 15 days of June. That approach, however, might give the systems people at the IRS and in the private sector fits.

issue date for the first accrual period). The record date is usually the business day before a payment date.

257b See footnote 38, above, for the definition of accrual periods. 257c The OID rules tolerate short initial interest holiday periods without requiring a yield adjustment.

See footnote 26, above, describing a special de minimis rule for an initial interest holiday—a lower rate for some period followed by a higher rate thereafter. Accruing interest based on payment dates is consistent with this rule because it places the interest holiday first.

Chapter 8

107

Whatever method is used, in the end, investors end up being taxed on their economic income through a combination of interest accruals and adjustments to sales prices. The market prices securities based on payment dates and payment amounts. Thus, the price at which a regular interest is sold will equal the present value at a market yield of the future payments the buyer will receive under the terms of the instrument. If one owner overaccrues or underaccrues taxable income because of the convention used in allocating taxable income among successive owners, that owner’s basis will be correspondingly overstated or understated and will at some point be offset by a loss or gain (or a reduction or increase in OID income). There could be timing and character differences, although likely not that large.

In August 2004, the Service entered the fray by issuing proposed regulations that would provide a special rule for accruing OID on REMIC regular interests that provide for a lag between record dates and interest payment dates of 30 days or less.257d The regulation would adopt the third approach outlined above (interest holiday at the end). Technically, they would do this by conforming the tax accrual periods over which interest or OID accrues to the periods between record dates (or the issue date and the first record date) rather than to the periods between payment dates. Principal received on a payment date would be treated (only for purposes of accruing OID under the PAC method) as if it were paid on the preceding record date. The IRS theory is that this produces better results, by conforming the tax accrual periods to the terms of the instrument (and thereby matching the party who has the income with the party who receives the cash). However, requiring an interest holiday at the end rather than accruing yield evenly over the entire term of the instrument means that a buyer will accrue no interest during the final holiday period with respect to principal the buyer receives. Thus, in the example above, if the remaining $50 of principal were paid to X on July 15 in full retirement of the regular interest, X would accrue interest on that $50 only for June even though it actually holds the regular interest for 45 days.

The government’s choice of method may have been influenced by an apparent misunderstanding of market practices. According to the preamble to the proposed regulations, the IRS believed that REMIC servicers computed taxable income based on accrual periods corresponding to the interval between payment dates and adjusted for the payment lag by provided for an interest holiday at the beginning (choice (2) of the three above). The IRS may have thought that choice was wrong because it conflicted with the terms of the instrument. Also, the IRS may have thought that having the holiday early rather than late inappropriately deferred income (or perhaps offended some puritan notion that the dessert—the holiday—should comes only after the meal). The deferral point is not a real revenue issue, however, as a deferral of income by holders would be matched by a deferral of deductions by the issuing REMIC, and the one party in the picture who is very likely to be paying taxes is the REMIC residual interest holder (reporting the taxable income, gross income less deductions, of the REMIC). At any rate, the practice seems to be different from what the IRS understood. According to one leading servicer, income is in fact reported over the entire period from the issue date to payment dates with no interest holidays.257e

257d See Proposed Regulation § 1.1275-2(m), which would be effective for regular interests issued

after the date final regulations are issued. 257e See letter dated February 9, 2005 to the IRS from Barry Silvermetz of Wells Fargo Bank, N.A.,

2005 Tax Notes Today 42-61 (which provides a good description of current practices and the rationale for them). The letter also recommends that if the IRS requires a change in tax accrual

Chapter 8

108

In the end, this appears to be a project the government should undertake only in response to industry request. The issues are not vital to the integrity of the tax system but have more to do with nitty-gritty administration; and the best people to judge those issues are those who do the work and the affected investors. The few published comment letters taking split positions on the issue suggest that this is not something the servicing industry is clamoring for, but perhaps someone (other servicers or investors) is whispering in the Service’s ear.257f

periods, they should be based on accrual periods under the terms of the regular interests, not record dates (because of distortions caused by business day conventions) and should apply to all instruments subject to the PAC method.

257f See unofficial transcript of IRS hearing on proposed regulations, held on November 17, 2004, 2004 Tax Notes Today 232-21 (representatives from KPMG and Wall Street Concepts participating); and a letter dated October 26, 2004 to the IRS from William E. Scott of Wall Street Concepts, 2004 Tax Notes Today 214-35 (acknowledging that having accrual periods based on payment dates can produce some distortions).

109

Chapter 9 Taxation of Holders of Equity Interests in Trust Issuers of Debt and REMIC Residual Interests

B. Common Tax Characteristics


The conduit issuer may also recognize income, gain or loss from any notional principal contracts to which it is a party.5a

Replace the sixth and seventh sentences in footnote 8 with the following:

On December 31, 2003, in T.D. 9107, the Service issued Treasury Regulation § 1.446-5 which requires debt issuance costs to be recovered over the term of the debt under a constant yield method, effective for debt instruments issued on or after December 31, 2003. See also P.L.R. 200525001 (March 11, 2005) (holding that in the case of callable debt that bears interest at a step rate, the issuer must use the term of the debt as determined under Treasury Regulation § 1.1272-1(c) (determined without regard to the decreased issue price computed under Treasury Regulation § 1.446-5(b)(1)) to allocate debt issuance costs related to the debt for purposes of Treasury Regulation § 1.446-5).

C. Special Considerations Applicable to Trust Issuers

Add to footnote 26, as third sentence before the end of the footnote:

The IRS has requested comments on whether the definition of “integrated financial transaction” should be expanded and whether the integrated financial transaction rules should be extended to financial services entities, such as banks and securities dealers, to which they do not now apply. See Notice 2001-59, 2001-41 I.R.B. 315.

D. Special Considerations Applicable to REMICs

The following comment applies to footnote 33:

As indicated in footnote 33, a REMIC is not allowed a deduction for taxes. This rule has become a practical problem in cases in which a REMIC is used to hold foreign mortgages that are subject to withholding taxes (e.g., Mexican loans). In the context of partnerships, foreign taxes are carved out in section 703(a)(2) on the ground that they are properly accounted for at the partner level (and may be either credited or deducted at that level). For REMICs, the taxes do not pass through as an expense or credit item, and the effect of disallowing a deduction is to require the residual interest holder to recognize additional noneconomic income. Unlike phantom income 5a The taxation of notional principal contracts is discussed in Chapter 8, Part H.3.a.

Chapter 9

110

arising from timing differences, that noneconomic income would not be reduced through an additional deduction in the REMIC but would be recovered only as a loss or reduced gain on liquidation of the REMIC or upon a sale of the residual interest. This problem should be fixed through a statutory change. The problem would create a reason to securitize foreign loans subject to withholding taxes using grantor trusts rather than REMICs.

The following replaces the final sentence of footnote 46 on pages 640-641:

There is a question whether the reduction in basis of qualified mortgages held by the REMIC would cause them to have market discount within the meaning of section 1278(a)(2). (The treatment of market discount is discussed in Chapter 8, Part E.) Section 1278(a)(2) defines market discount as the excess of the stated redemption price of a debt instrument at maturity over its basis “immediately after its acquisition by the taxpayer.” There does not appear to be any rule that would treat a REMIC as newly acquiring assets due to a reduction in basis under section 1017. See also section 1017(c)(2) (reduction in basis not a disposition).

Add the following at the end of page 644:

It is a common practice for REMIC securities to be issued in a tiered structure in which a lower-tier REMIC issues all of its regular interests to an upper-tier REMIC. See Chapter , Part D.7.a. Each REMIC issues a separate class of residual interests, and often the two classes are sold and held together as a package. Apparently, if there are periods in which losses are allocated to the residual interest in one REMIC and taxable income allocated to the residual interest in the other REMIC, the two amounts are sometimes simply netted, at least for purposes of pricing the residual package. There is, however, no rule in the tax law that allows such netting directly. Accordingly, whether netting produces the right end result depends on whether the loss would be allowed as a stand-alone item. That in turn depends on whether the holder has sufficient basis in the particular residual interest producing the loss to absorb the loss and sufficient income other than excess inclusion income against which to offset the loss.

The netting approach apparently stems from disbelief that a lower-tier REMIC can ever produce significant income or losses if the calculations are done properly. The cash flows on REMIC assets typically match in the aggregate the cash flows on regular interests (residual interests are typically noneconomic) and, in a lower-tier REMIC, all classes of regular interests are aggregated for purposes of applying the OID rules, eliminating the main cause of phantom income. See the discussion of phantom income in Part E, below. However, patterns of income and losses can potentially arise not only from tranched liabilities but also from the ownership by the lower-tier REMIC of a heterogenous pool of assets (typically, regular interests in other REMICs) that have, for tax purposes, different yields. For a discussion of how to apply the PAC method to a pool of assets, see Chapter 8, Part G.3. Thus, if there are income and loss amounts in a lower-tier REMIC, it cannot be assumed that they are wrong, particularly where the REMIC has a mixed asset pool. Determining if they are wrong or at least open to question requires an examination of the facts and the reasons for the income or loss. A holder of a REMIC residual interest is not required to follow the income amounts reported to it on a Schedule Q if the holder believes they are wrong, but the holder may be required to flag any inconsistencies on its tax returns. See Chapter 6, Part E.2.a.


Chapter 9

111

Under section 1091(f), added by the Community Renewal Tax Relief Act of 2000 (CRTRA 2000) effective December 21, 2000, the wash sales rules do not fail to apply to a contract or option to acquire or sell stock or securities solely by reason of the fact that the contract or option is, or could be, settled in cash (or other property) rather than such stocks or securities. Prior to CRTRA 2000, many taxpayers took the position that a contract or option to acquire stock or securities that settled in cash was not a contract or option to acquire stock or securities for purposes of the wash sales rules, since the cash settlement of an option is treated as the disposition of the option (rather than, for example, the deemed exercise of the option followed by a deemed sale of the property subject to the option). See Revenue Ruling 88-31, 1988-1 C.B. 302.


The wash sale rules apply only to limit a loss deduction under section 165 and, accordingly, should not apply to limit deductions for inducement payments. Losses under section 165 from the sale or disposition of property are limited to the basis of the property involved, and the deduction for an inducement payment is not linked to the basis in a residual interest.63a There is no similar computation for inducement payments; they represent a pure expense item. A similar question arises in applying the straddle rules to notional principal contracts, but without clear authority addressing the point.63b In policy terms, it makes sense to draw a distinction between a loss from a disposition of a residual interest that reverses prior inclusions of phantom income (which would be reflected in the basis of the residual interest) and an inducement payment. Congress adopted a number of safeguards to ensure taxation of phantom income, and the wash sale rules can readily be understood as one measure to limit taxpayers’ ability to reduce the phantom income cost through loss-generating sales. By contrast, a deduction allowed for an inducement payment generally would be matched with an income inclusion on the other side (see Part E.4.g.(ii), below). There is no obvious reason to defer the deduction to make the REMIC

63a Treasury Regulation § 1.165-1(c)(1) states that the amount of loss allowable as a deduction under

section 165(a) shall not exceed the adjusted basis for determining loss from the sale or other disposition of the property involved. A negative value residual interest typically has an initial basis of zero and a deduction for an inducement payment is attributable to the cash paid, not basis in the residual interest.

63b Section 1092(a)(1)(A) limits deductions for a “loss” with respect to a position. Treasury Regulation § 1.1092(b)-5T(d) states that the term “loss” means a loss otherwise allowable under section 165(a) (without regard to the rule limiting capital losses to capital gains) and includes a write down of inventory. For a discussion of whether swap payments involve a “loss,” see Edward D. Kleinbard and Erika W. Nijenhuis, “Short Sales and Short Sale Principles in Contemporary Applications,” N.Y.U. Fifty-Third Institute on Federal Taxation, (Matthew Bender, 1995), footnotes 109 and 112; New York State Bar Association, Tax Section, “Report on Notional Principal Contract Character and Timing Issues,” 98 Tax Notes Today 104-78 (May 18, 1998), footnote 7 (expressing some disagreement about result). The IRS has asked for comments on the point. See Chapter 8, footnote 237b and accompanying text (in this Supplement). Contingent payment debt instruments (CPDIs) raise a similar issue under the straddle rules in that losses from declines in value of property may be built into the terms of such instruments as interest adjustments and not as traditional losses. The CPDI regulations have a special rule treating negative adjustments to interest as losses for purposes of the straddle rules. Treasury Regulation § 1.1275-4(b)(9)(vi). The tax rules governing CPDIs are summarized in Chapter 8, Parts C.3 and C.4.e.

Chapter 9

112

rules function properly. The status of inducement payments as an expense or loss is not significant for any payor that sells residual interest in a dealer capacity.63c

Add the following new paragraph at the end of Part D:

As a result of the recognition of REMIC income, a residual interest may have an adjusted basis significantly greater than its fair market value. Recent legislation limits the ability of taxpayers to use that high basis to duplicate losses through carryover basis transfers of residual interests to corporations.65a

Although taxable income from a REMIC is taxable currently to holders of the residual interest, a REMIC is generally considered a separate entity from the residual interest holders and they are not considered to earn directly the gross income items of the REMIC or to hold its assets subject to the indebtedness represented by the regular interests. Accordingly, for purposes of allocating interest expense in determining the foreign tax credit limitation of a residual interest holder, interest expense of the REMIC should not be attributed to the holder and the holder should not be considered to own the REMIC’s gross assets (as distinguished from the residual interest itself).65b

E. Phantom Income

4. Special Rules for REMICs—Excess Inclusions and Negative Value Residual Interests

a. Overview

Add the following after the third sentence (ending with “section 172”) in footnote 75:

Revenue Ruling 2005-68, 2005-44 I.R.B. 853, illustrates the interaction of the excess inclusion and NOL carryover/carryback rules (but otherwise seems to add very little to a plain reading of the statute). FSA 1997 WL 33314781 (March 13, 1997) holds that a domestic source loss that is carried back because it cannot be offset against domestic source excess inclusion income in a later year retains its status as a domestic source loss for purposes of computing the taxpayer’s foreign tax credit limitation notwithstanding that the loss would have reduced foreign source

63c See footnote 62, above, for a description of the dealer exception. Although section 1091 does not

incorporate the broader definition of securities dealer found in section 475 (mark-to-market rules for securities dealers), a taxpayer that originates loans for sale through securitizations may well be a securities dealer under the traditional definition. See Chapter 11, footnote 63 and accompanying text.

65a See Part E.4.i. (in this Supplement). 65b For a discussion of allocations of interest expense for purposes of computing the foreign tax credit

limitation, see Chapter 16, Part H.6 (in the book and this Supplement). Part H.6 (in the book) discusses Proposed Regulation § 1.861-10T(f), which would specially allocate interest expense from FASITs to income earned as the owner of a FASIT on an affiliated group basis. See also Notice 2001-59, discussed in Chapter 9, Part C (in this Supplement), seeking comments on whether interest expense should be directly allocated against interest income from closely related financial instruments.

Chapter 9

113

income in the later year if the excess inclusion income had been “walled off”. The FSA is somewhat hard to follow because of text redactions.


Section 1616(c)(4) of SBJPA 1996 has a transition rule that prevents the SBJPA 1996 amendments from applying to “any residual interest held by a taxpayer if such interest has been held by such taxpayer at all times after October 31, 1995.” If a thrift transferred a residual interest in a carryover basis transaction, the acquirer should be allowed to tack the thrift’s holding period for purposes of applying the transition rule under the holding period rules in section 1223(2). That section applies for purposes of subtitle A of the Code (the income tax) and not just in determining whether capital gains or losses are long-term. Of course, in addition to establishing that the transition rule continues to apply, if would be necessary to consider whether the transfer of an asset causes the benefit of the special thrift rule from being lost under pre-SBJPA 1996 law.


AJCA 2004 repealed the rule limiting the foreign tax credit to 90 percent of the AMT (before the credit), effective for taxable years beginning after December 31, 2004.


The Service has interpreted section 860E(a)(2) to require the excess inclusion floor to be applied at the consolidated group level, even where taxable income is otherwise first computed at a subgroup level. Specifically, section 860E(a)(2) must be applied to total consolidated income of a group including life insurance company and non-life members, despite the fact that Treasury Regulation § 1.1502-47 requires such a group to calculate taxable income initially on a subgroup basis. See T.A.M. 200404034 (September 2, 2003): “The requirement that life-nonlife groups calculate their taxable income initially on a subgroup basis does not require the comparison of excess inclusions to taxable income to be made on a subgroup basis. The comparison of excess inclusions to taxable income under section 860E(a) is not part of the calculation of consolidated taxable income but a requirement that once consolidated taxable income is calculated, consolidated taxable income may not be less than the aggregate excess inclusions of the members. Because this comparison is not part of the calculation in arriving at subgroup taxable income, the subgroup rules do not literally apply.”

c. Pass-thru Entities

Add the following footnote 88a at the end of the second full paragraph on page 658:

88a A RIC or REIT may only claim a dividends paid deduction for distributions that are treated as dividends for tax purposes (and therefore are includible in income by shareholders). See section 562(a). A dividend is defined in section 316(a) as a distribution out of current or accumulated earnings and profits. In a case in which a RIC or REIT has excess inclusion income in excess of its regular taxable income, a question may arise as to whether it has earnings and profits sufficient to support a dividend. For example, suppose that in a given taxable year a REIT with no accumulated earnings has 100 of excess inclusion income from a REMIC residual interest and 50 of unrelated ordinary deductions. If the REIT declared a dividend of 100 to eliminate the excess

Chapter 9

114

inclusion income, would it have earnings and profits sufficient to support the dividend? The answer is yes, under section 857(d)(1). It provides that the earnings and profits of a REIT for any taxable year (but not accumulated earnings and profits) shall not be reduced by any amount which is not allowable in computing its taxable income for such year. Because of the excess inclusion rules, the REIT is effectively denied a deduction for the 50 of expenses in the year, so that those expenses also should be ignored in calculating earnings and profits for the year. There is a similar provision for RICs in section 854(c)(1). The REIT in this example would be allowed to carry over the loss of 50 to future years under section 172 (REITs are not allowed carrybacks).

Add the following at the end of the second sentence of the last paragraph starting on page 658:

to the extent REIT or RIC income is reduced below the amount of excess inclusion income through deductible dividend distributions.88b In addition, the treatment under section 860E(d), of REIT and RIC dividends as excess inclusions (to the extent arising from excess inclusions) only makes sense if the REIT or RIC, itself, is able to avoid tax on its excess inclusions.


Recently, the Service addressed a problem that arises when a charitable remainder trust (subject to section 664) is allocated excess inclusion income through a pass-through entity. Such a trust is generally tax exempt, but until recently the exemption was lost if it earned any UBTI. In a 2006 Revenue Ruling,89a the Service clarified that because a charitable remainder trust is not an entity subject to tax on UBTI under section 511, excess inclusion income allocated to such a trust would not be UBTI in its hands. As a result, the trust would retain its tax-exempt status and be treated as a disqualified organization, so that the pass-through entity would be responsible for paying tax on the excess inclusion income. Section 664 has been amended effective for taxable years beginning after December 31, 2006 to replace the loss of tax exemption for a trust earning UBTI with a 100 percent excise tax on UBTI, but the result should be the same under the amended statute (the section 511 tax still does not apply to UBTI of the trust).

Notice 2006-9789b was issued at the end of 2006 in response to taxpayer requests to address the following issues:

• The proper computation of excess inclusion income of a REIT (or qualified REIT subsidiary) that is a TMP under section 7701(i)(3);89c

88b Note that a REIT is not always required to distribute out excess inclusion income to qualify as a

REIT. Section 857(a) generally requires a REIT to pay out dividends equal to at least 90 percent of its taxable income (other than net capital gains and certain income from foreclosure property). However, the otherwise-required distribution is reduced by the amount of any “excess noncash income” defined in section 857(e). That term includes among other things OID and excess inclusion income to the extent not paid in cash or property in excess of 5 percent of the REIT’s taxable income (other than net capital gains).

89a Revenue Ruling 2006-58, 2006-46 I.R.B. 876. 89b 2006-46 I.R.B. 904.

Chapter 9

115

• The proper method for allocating excess inclusion income among the dividends paid by REITs and RICs during the taxable year;

• The reporting obligations of REITs and RICs and their shareholders with respect to excess inclusion income;

• If excess inclusion income is allocated to, or otherwise recognized by, an organization that is subject to tax under section 511, whether the $1,000 deduction provided by section 512(b)(12) is available; and

• Whether there is or will be a de minimis exception that applies to REITs, RICs, and other pass-through entities that have only small amounts of excess inclusion income.

Taxpayers had also requested that sections 860E(d) and 7701(i)(3) apply only prospectively after the issuance of regulations.

Notice 2006-97 provides that sections 860E(d) and 7701(i)(3) establish basic principles that

are applicable even in the absence of regulations (i.e., they are self-executing). The Notice sets out certain principles that are applicable pending further guidance:

• REITs must calculate excess inclusion income from a REIT TMP under a

“reasonable method” (no further explanation is given).

• All pass-thru entities, including REITs, RICs and nominees, must (1) generally allocate excess inclusion income among owners in accordance with applicable provisions (e.g., section 702 for a partnership) and inform owners that are not disqualified organizations of the amount and character of the excess inclusion income allocated to them, (2) pay any tax imposed by section 860E(e)(6) on excess inclusion income allocable to owners that are disqualified organizations, and (3) withhold any amounts on excess inclusion income allocated to foreign persons required pursuant to section 860G(b)(2).

• A RIC or a REIT must allocate excess inclusion income to its shareholders in proportion to dividends paid, without regard to any tax paid under section 860E(e)(6).

• Pending further guidance, and except as described below, a RIC is not required to report excess inclusion income allocated to shareholders who are not nominees.

• For RIC taxable years beginning on or after January 1, 2007, a RIC is required to report excess inclusion income allocated to shareholders that are not nominees (1) if excess inclusion income exceeds 1 percent of a RIC’s gross income or (2) the excess inclusion income represents income allocated to the RIC from a REIT that, for the most recent REIT taxable year ending not later than nine months before the first day of the

89c As discussed in Chapter 10, Part D, section 7701(i)(3) provides that if a REIT, or a qualified REIT

subsidiary, is a TMP (a “REIT TMP”), adjustments similar to the adjustments provided in section 860E(d) are to apply to the shareholders of the REIT. Regulations on making such adjustments have not yet been issued.

Chapter 9

116

RIC’s taxable year, reported excess inclusion income exceeding 3 percent of the REIT’s total dividends for the year.

ICI and NAREIT, associations representing RICs and REITs, responded to the notice, urging the Service to delay the effective date of the interim guidance because additional time and further clarification were needed to implement the reporting, calculation and withholding requirements. They also requested further de minimis exceptions.89d NAREIT also suggested two methods for calculating excess inclusion income from a REIT TMP.89e

e. Certain Tax-Motivated Transfers Disregarded

Replace Part E.4.e.(i) with the following:

(i) Transfers to U.S. persons. On July 19, 2002, the IRS published final regulations under Treasury Regulation § 1.860E-1(c) that amend the safe harbor rule described in the book on page 665 (beginning with the second full paragraph). The final regulations, which are reproduced in Appendix C (in this Supplement), make the following changes:

• To qualify for the safe harbor for transfers after August 19, 2002, the transferee

must represent that it will not cause income from the noneconomic residual interest to be attributable to a foreign permanent establishment or fixed base (within the meaning of an applicable income tax treaty) of the transferee or another taxpayer.

• The regulations preserve the formula test described in the bullet point ending with footnote 112, but make three changes: (1) in computing the present value of future tax liabilities, the (lower) alternative minimum tax rate specified in section 55(b)(1)(B) may be used in lieu of the highest marginal corporate tax rate if the transferee has been subject to the alternative minimum tax under section 55 in the preceding two years and will compute its taxable income in the current taxable year using the AMT rate, (2) for transfers after August 19, 2002, the discount rate used in computing present values must be the Federal short-term rate prescribed by section 1274(d) for the month of the transfer (and not the taxpayer’s actual cost of funds if lower), and (3) the formula test may not be

89d See letters from Investment Company Institute at 2007 Tax Notes Today 7-25 (January 10, 2007)

and National Association of Real Estate Investment Trusts at 2007 Tax Notes Today 26-21 (February 7, 2007). The NAREIT letter recommended a de minimis exception to the reporting requirements for all pass-thru entities, instead of just RICs, that would excuse reporting of excess inclusions not exceeding 1% of the total dividends or other taxable income the entity reports to its owners.

89e Under the “synthetic REMIC method,” excess inclusion income would be calculated by treating the REIT TMP as a REMIC and the equity interest as comprised of (i) a synthetic regular interest entitled to all of the cash flows associated with the equity interest and (ii) a synthetic non-economic residual interest. The issue price of the synthetic regular interest would be its fair market value at issuance and would be treated like a REMIC regular interest for purposes of calculating excess inclusion income on the synthetic residual interest. Because the issue price of the synthetic residual interest would be zero, any income on it would constitute excess inclusion income. Under the “economic residual” method, excess inclusion would be determined by treating the REIT TMP as a REMIC. However, the equity interest in the TMP (including any other interests issued and retained by the REIT TMP) would be treated as an economic REMIC residual interest.

Chapter 9

117

relied upon for a direct or indirect transfer of a residual interest to a foreign permanent establishment or fixed base (within the meaning of an applicable income tax treaty) of a domestic transferee (this duplicates the more general change to the safe harbor rule described above).

• The regulations preserve the asset test described in the bullet point ending with footnote 112, but rephrase slightly the prohibition on transfers to foreign branches to prohibit the direct or indirect transfer of a residual interest to a foreign permanent establishment (within the meaning of an applicable income tax treaty) of a domestic corporation (a fixed base is not mentioned, but presumably no difference is intended).

While the final regulations alter the safe harbor rule and not the definition of improper knowledge in Treasury Regulation § 1.860E-1(c)(1), a statement in the preamble to T.D. 9004 adopting the revised safe harbor indicates that the Service believes that the presumption of no improper knowledge is never met for transfers to foreign branches:

Rev. Proc. 2001-12 provides that the asset test fails to be satisfied in the case of a transfer or assignment of a noneconomic residual interest to a foreign branch of an otherwise eligible transferee. If such a transfer or assignment were permitted, a corporate taxpayer might seek to claim that the provisions of an applicable income tax treaty would resource excess inclusion income as foreign source income, and that, as a consequence, any U.S. tax liability attributable to the excess inclusion income could be offset by foreign tax credits. Such a claim would impede the assessment or collection of U.S. tax [the phrase used in Treasury Regulation § 1.860E-1(c)(1)] on excess inclusion income, contrary to the congressional purpose of assuring that such income will be taxable in all events. See, e.g., sections 860E(a)(1), (b), (e) and 860G(b) of the Code.

(ii) Transfers to foreign investors


At a Tax Executives Institute conference in October 2002, IRS officials announced a compliance initiative aimed at taxpayers who transfer noneconomic REMIC residual interests to foreign investors (including partnerships owned by foreign investors) who will not pay taxes on phantom income, and threatened to impose penalties.129a

In May 2003, another case involving transfers of REMIC residual interests to partnerships with foreign partners was docketed in the Tax Court.129b The taxpayer was the Diversified Financial Corporation. On July 26, 2004, the IRS issued IR-2004-97 (2004 I.R.B. LEXIS 324) announcing that it had reached a settlement of pending disputes with Diversified and another unrelated taxpayer, AVM L.P., relating to transfers of noneconomic REMIC residual interests to domestic limited liability companies (taxed as partnerships) with foreign partners. In the announcement, the IRS notes that for some time it has been concerned that buyers of noneconomic residual interests have attempted to avoid taxes on phantom income by taking an overly aggressive interpretation of the applicable tax rules. The announcement specifies that the

129a See 2002 Tax Notes Today 201-6 (October 11, 2002). 129b See The Diversified Group Incorporated v. Comm’r, T.C. Docket No. 7199-03 (May 15, 2003).

Chapter 9

118

terms of the settlement required each of Diversified and AVM to disgorge its profits to the IRS, imposed penalties and interest, and enabled the IRS to pursue other participants in the same or related transactions. The IRS also noted that the settlement “preemptively shuts down the deduction of over $1 billion in phantom tax losses arising from the [nonecomic residual interests],” the total payment to the IRS from the two companies was in the “eight figures” and the companies had agreed to cease and desist from engaging in future noneconomic residual interest trading activities and to a limited waiver of the taxpayer privacy and anti-disclosure rules.

In July 2006, the IRS issued temporary regulations that require domestic partnerships that allocate income from REMIC residual interests to foreign partners to withhold tax on the income, even if no distributions are made to the foreign partners. The regulations are described further in Chapter 12, Part C.1 (in this Supplement).


The rule is effective for transfers of residual interests on or after September 27, 1991. See Treasury Regulation § 1.860A-1(b)(2)(i). Note that the rule requires only a tax avoidance effect, not a purpose. Transfers are disregarded for purposes of sections 871(a), 881, 1441 or 1442, which are the withholding tax sections. For a discussion of the withholding tax rules applicable to REMIC residual interests, see Chapter 12, Part C.1, following footnote 35. In theory, the foreign selling holder would be required to file a return and pay withholding tax as a result of the transfer, but that civic obligation is not reinforced by requiring the buyer to withhold out of the purchase price. See Chapter 12, footnotes 31 and 39.

f. Flaws in Excess Inclusion Rules

Add the following as a new footnote 129a at the end of the penultimate paragraph on page 673: On the other hand, there is no specific rule treating a disposition of a residual interest as a sale. As a result, there may be a good argument that the payment of an inducement fee to another person to take a residual interest off one’s hands is not treated as a sale for tax purposes and thus does not cause the loss on disposition to be a capital loss. See Revenue Ruling 93-80, 1993-2 C.B. 239 (“absent a sale or exchange, a loss that results from the abandonment or worthlessness of nondepreciable property is an ordinary loss even if the abandoned or worthless asset is a capital asset (such as a partnership interest)”). Although the transferee would be subject to tax liabilities that otherwise would be borne by the transferor, those liabilities are personal to the parties and are not liabilities of the transferor assumed by the transferee. Some consideration should be given to the possible application of section 1234A (which treats gains or losses from terminations of rights or obligations with respect to capital assets as sales or exchanges), although a sale of a residual interest is more likely to be considered an assignment than a termination. With a view to preventing taxpayers from avoiding capital loss treatment for worthless securities under section 165(g) through abandonments, the Treasury adopted final regulations to treat abandonments as transactions evidencing worthlessness. Treasury Regulation § 1.165-5(i) provides that an abandoned security qualifies as a worthless security under section 165(g) and the resulting loss may be deducted under section 165(a). A loss on a security held as a capital asset generally is treated as a loss from the sale or exchange of a capital asset on the last day of the taxable year. Abandonment of a security requires a taxpayer to permanently surrender and relinquish all rights in the security, without receiving any consideration. A loss arising from the

Chapter 9

119

abandonment of securities in certain affiliated corporations, with respect to which the taxpayer meets specified ownership tests, however, are treated as an ordinary loss notwithstanding that such securities may be held as capital assets. The provision applies to securities abandoned after March 12, 2008. T.D. 9386, 2008-16 I.R.B. 788. For an article discussing the regulation prior to finalization, see Robert Willens, “What is the Character of an ‘Abandonment’ Loss?” 116 Tax Notes Today 1001 (Sept. 10, 2007). Because REMIC residual interests are not securities under section 165(g), the regulations do not cause the loss from a disposition of a residual interest that is not a sale or exchange (that is, as is typical with non-economic residual interests, disposing of the residual interest without receiving any consideration in return) to be a capital loss. See Revenue Ruling 93-80, 1993-2 C.B. 239 (“absent a sale or exchange, a loss that results from the abandonment or worthlessness of nondepreciable property is an ordinary loss even if the abandoned or worthless asset is a capital asset (such as a partnership interest).”).

g. Negative Value Residual Interests


For an extensive analysis of how inducement payments should be taxed, see Carol Schwartz, “Taxing REMIC Inducement Payments,” Journal of Taxation of Financial Products (Fall 2001), 41. The author sets out arguments for and against alternative approaches: current inclusion of an inducement payment in income of the payee, spreading the payment over a reasonable fixed period, or spreading the inclusion over the expected life of the residual interest and adjusting amounts based on actual performance of REMIC assets. She describes current inclusion as arguably the current state of the law (as of 2001).

Delete the sentence accompanying footnote 135 and footnote 135 on page 676 and replace the balance of section h with the following:

In May 2004, the IRS issued regulations that prohibit inducement fees from being

recognized when received.134a Instead, in order to clearly reflect income, an inducement fee must be recognized over the remaining expected life of the REMIC in a manner that reasonably reflects the after-tax costs and benefits of holding the residual interest, regardless of the taxpayer’s overall method of accounting.134b The regulations are effective for taxable years ending after May 11, 2004 (without regard to when a residual interest is acquired). Changes in accounting methods for inducement fees are discussed below.

The regulations provide two safe harbor methods of accounting for inducement fees—the

134a Treasury Regulation § 1.446-6, adopted by T.D. 9128, 2004-21 I.R.B. 943. The regulations were

accompanied by Revenue Procedure 2004-30, 2004-21 I.R.B. 950, providing guidance on changing methods of accounting for inducement fees. This revenue procedure is described further below.

134b Treasury Regulation § 1.446-6(c). By their terms, the regulations apply only to fees paid to induce a person to become the owner of a noneconomic residual interest (as defined in the text above at footnote 109). It seems unlikely that a different approach would apply to an economic residual interest (assuming the tax costs of ownership outweigh the economics so that an inducement fee would be paid upon a transfer).

Chapter 9

120

book method and the modified REMIC regulatory method.134c Under the book method, an inducement fee is recognized in accordance with the method of accounting, and over the same period, that is used by the taxpayer for financial reporting purposes (provided the period is not shorter than the period during which the REMIC is expected to generate taxable income).134d Under the modified REMIC regulatory method, an inducement fee is recognized ratably over the remaining anticipated weighted average life of the REMIC (determined as of the date of acquisition of the residual interest).134e

Regardless of the amortization method used, the holder of a residual interest must include in income the unrecognized portion of the inducement fee at the time of disposition of the residual interest.134f The regulations also provide that an inducement fee is treated as income from sources within the United States.134g

Finally, the regulations provide that the treatment of inducement fees is a method of accounting that must be applied consistently to all inducement fees received in connection with noneconomic REMIC residual interests. 134c In the preamble to the proposed regulations issued in July 2003, the IRS had requested comments

on other possible safe harbor methods of accounting, in particular, on a method that took fees into income in proportion to the anticipated future cost of funding tax costs from holding the residual interest. No comments were received.

134d Treasury Regulation § 1.446-6(e)(1). The regulation refers to the method used “for financial reporting purposes (including consolidated financial statements to shareholder, partners, beneficiaries, and other proprietors and for credit purposes).” It is not clear what statements would be used if there were more than one using inconsistent methods. There is no requirement that the financial statements be in accordance with generally accepted accounting principles or audited. Although not entirely clear, if the amortization period used in financial statements is shorter than the period over which taxable income is expected to be generated, the safe harbor would not appear to apply (as distinguished from applying based on that expected period). Given, however, that the rule is only a safe harbor, it would seem to be reasonable in such a case to use the financial statement method over the longer period during which taxable income is expected. The safe harbor rule does not require that expectations of taxable income be based on the Prepayment Assumption used in applying the PAC method to the REMIC (see Chapter 8, Part F.3), although presumably that approach would be accepted.

134e Treasury Regulation § 1.446-6(e)(2). The method is the same one used by a REMIC sponsor in taking into income gain that is not recognized upon a transfer of mortgages to a REMIC in exchange for the residual interest. For a description of that method and the definition of the anticipated weighted average life of a REMIC (generally a weighted average of the anticipated lives of all REMIC classes computed using the Prepayment Assumption used in applying the PAC method to regular interest classes), see Chapter 15, footnote 62.

134f Treasury Regulation § 1.446-6(d). There is an exception for carryover basis transactions described in section 381(c)(4) (certain reorganizations and subsidiary into parent corporate liquidations). The preamble to the proposed regulations indicates that the IRS made a conscious choice not to extend the exception to carryover basis transfers made to corporations or partnerships under sections 351 and 721 because those sections do not provide for the carryover of tax attributes generally.

134g Treasury Regulation § 1.863-1(e). For U.S. taxpayers, the source of income rule is significant mostly in determining the foreign tax credit limitation under section 904 (credits are limited to a fraction of the U.S. income tax equal to domestic source taxable income divided by worldwide taxable income).

Chapter 9

121

Under general tax principles, once a taxpayer has adopted a method of accounting for inducement fees, it may not change that method without the prior consent of the IRS, which may condition consent on the taxpayer making adjustments necessary to prevent amounts of income (and deductions) from being duplicated or omitted. The IRS issued together with the inducement fee timing regulations a revenue procedure granting automatic consent to a change in accounting method to one of the two safe-harbor methods described above.134h To obtain such consent, a taxpayer must file a Form 3115 with the IRS for the year of change. Beginning in that year, the taxpayer would compute income from inducement fees in accordance with the chosen safe harbor rule with respect to all noneconomic residual interests it owns. With respect to residual interests acquired in a prior year, the taxpayer must make an adjustment under section 481(a) equal to the difference between the amount of fees actually included in taxable income in prior years and the amount that would have been included in income under the new method. That difference would generally be taken into account ratably over the four taxable years beginning with the year of change. The balance of the adjustment may be accelerated in certain circumstances.

To illustrate, suppose a calendar year taxpayer had adopted a method of accounting for inducement fees prior to 2004 under which fees were treated as income when received. That taxpayer switches to a safe harbor method for the 2004 tax year. Taxable income for 2004 and future years would be computed under the safe-harbor method as if it had been in place in all relevant years. For residual interests acquired before 2004, the taxpayer would compute the excess, for all years before 2004, of the fees received and included in income over the amount of fees that would have been included in income under the new method. (There would be no difference, of course, for residual interests that had been acquired and disposed of before 2004.) One-quarter of that excess would be allowed as a deduction under section 481(a) in each of 2004, 2005, 2006 and 2007 (assuming each is a taxable year). The net result of the change in accounting method with respect to residual interests acquired before 2004 would be an acceleration of taxable income or a deferral for 2004 and future years depending on whether the new safe harbor method requires inclusions of unamortized fees in income faster or slower than ratably over four years.

If a taxpayer wishes to switch to an accounting method for inducement fees that is consistent with the new regulations but is not a safe harbor method, it must obtain IRS consent (which may be refused) following the procedures that apply when automatic consent is not available.134i

Add the following new Part E.4.i.:

i. Uses of REMIC Residual Interests to Duplicate Losses. Due to the realization of phantom income, a REMIC residual interest may acquire a tax basis greatly in excess of its fair

134h Revenue Procedure 2004-30, 2004-21 I.R.B. 950. The revenue procedure requires that a taxpayer

comply with the procedures for obtaining automatic consent set forth in Revenue Procedure 2002-9, 2002-1 C.B. 327. The discussion that follows in the text is based on Revenue Procedure 2002-9 (and specifically the requirement to file Form 3115 set forth in section 6 and the calculation of the section 481(a) adjustment in section 5). Section 5.03 of Revenue Procedure 2002-9 contemplates that a section 481(a) adjustment will be made unless the IRS provides for use of a cut-off method that essentially grandfathers the old accounting method for items arising before the year of change. Revenue Procedure 2004-30 does not authorize use of a cut-off method for inducement fees.

134i See section 2.03 of Revenue Procedure 2004-30, referring to Revenue Procedure 97-27, 1997-1 C.B. 680, as modified.

Chapter 9

122

market value. A holder may accelerate the potential loss by disposing of the residual interest in a taxable transaction. A more aggressive approach may seek to duplicate the loss by transferring the residual interest to a corporation in a section 351 transaction in exchange for stock of the corporation or stock and other property.149 In that event, the corporation acquires the residual interest with the same (high) basis as the transferor (a carryover basis) and the former owner also preserves the loss by maintaining the same high basis in the stock.150 One disadvantage for the transferor is that loss on sale of the stock may be a capital loss. Also, to ensure qualification of the transfer under section 351, the transferor may be required contractually to hold the stock (and defer its loss) for some period. In addition to meeting the technical requirements of section 351, to effectively duplicate a loss, a taxpayer must overcome other technical obstacles. A discussion of these is beyond the scope of this book.151

The ability to achieve these results has recently been curbed through legislative changes spawned in significant part by well-publicized transactions involving REMIC residual interests. The JCT Enron Report, released on February 13, 2003, discussed two transactions (Projects Steele and Cochise) in which a bank holding high-basis, low-value REMIC residual interests transferred those interests to an Enron subsidiary in a section 351 transaction.152 The report recommended that the law be changed so that either a corporation’s basis in REMIC residual interests acquired in a tax-free transfer (or reorganization) be limited to its fair market value or a transferor’s basis in the stock received in exchange for REMIC residual interests be limited to the fair market value of the REMIC residual interests.

Following the lead of the JCT Enron Report, AJCA 2004 amended the basis carryover rules applicable to transfers of any kind of loss property (not just REMIC residual interests) in a section 351 transfer, or from a foreign or other non-tax paying corporation in a reorganization or section 332 liquidation, generally to limit the basis in the hands of the transferee to fair market value. In

149 Section 351 provides that if one or more persons transfer property to a corporation solely in

exchange for stock and, immediately after such transfer, those persons are in control of the corporation (own 80 percent of the voting power of the voting stock and 80 percent of each class of nonvoting stock), then no gain or loss is recognized upon the exchange of property for stock. Section 356 states that if stock and other property are received, then realized gain is recognized up to the value of the other property and no loss is recognized.

150 The transferee corporation takes a carryover basis in transferred property under section 362(a) (corporation’s basis is the same as transferor’s, increased by gain recognized by transferor). Under section 358(a), the transferor’s basis in stock and other property received equals his basis in the property transferred, reduced by the fair market value of the other property (which takes a fair market value basis) and increased by any gain recognized.

151 The limitations include section 269 (limits the use of tax attributes of a corporation if control of the corporation is acquired with the principal purpose of using those tax attributes), section 382 (limits losses of loss corporation following a greater than 50 percent change in ownership; can apply if transferor of loss assets is a loss corporation), section 482 (generally, aims to place transactions between related persons on an arm’s length basis, but also can be used to prevent the shifting of losses to controlled entity without an adequate business purpose), and the SRLY rules (Treasury Regulation § 1.1502-15 treats built-in losses or deductions from property acquired in a carryover basis transaction as separate return limitation year losses that can be used in a consolidated return only to offset income of the corporation that realizes the loss or its successor).

152 For a lively discussion of Projects Steele and Cochise, see Lee A. Sheppard, “Enron’s REMIC Deals: Tax Shelter Or Attractive Nuisance?” 2003 Tax Notes Today 47-7 (March 10, 2003).

Chapter 9

123

the case of a section 351 transfer, both transferor and transferee may elect to carry over the high basis in the asset to the transferee, but if the election is made, the transferor’s basis in the stock received for the property is limited to its fair market value.153 The changes are effective for transactions and liquidations after October 22, 2004.

153 See sections 362(e) and 334(b)(1)(B). Proposed Regulation § 1.362-4 would provide rules

implementing section 362(e)(2). For a critique of a similar earlier version of the legislation, see James M. Peaslee, “Revenue Raisers in the Senate JOBS Bill—Unintended Consequences and Better Choices,” Tax Notes, February 2, 2004, 621.

124

Chapter 10 Taxation of Taxable Mortgage Pools and Holders of Equity Interests in Taxable Mortgage Pools C. Taxation of Equity Holders

Add at the end of the section:

Legislation enacted in 2003 reduced the maximum tax rate on qualified dividend income for individuals to 15 percent.15a There is no rule that would prevent dividends paid by a TMP from being qualified dividend income.

D. REITs

1. Taxation of REITs

Add the following after the first paragraph in this section: In very general terms, under section 857(a), for any taxable year for which REIT status is sought, a REIT must distribute to its shareholders at least 90 percent of its REIT-TI (excluding net capital gain and prior to taking account of the dividends paid deduction) minus its “excess noncash income.” Excess noncash income is defined in section 857(e) to include various items of income to the extent they exceed cash or property received (but only in the amount by which those items in the aggregate exceed five percent of the REIT-TI, excluding net capital gain and prior to taking account of the dividends paid deduction). Those income items include OID on a debt instrument and income from the ownership of a REMIC residual interest. Excess noncash income that is not distributed by a REIT is subject to a double tax like income of a conventional taxable corporation (there is no increase in the shareholders’ bases in their REIT stock for such income, unlike the treatment accorded to undistributed capital gains under section 857(b)(3)(D)(iii)).

2. REIT/TMPs as Quasi REMICs

Treasury Regulation § 1.856-9, adopted by T.D. 9183, effective April 1, 2004, provides that a qualified REIT subsidiary, even though it is otherwise disregarded and treated as part of the REIT, is treated as a separate corporation for certain procedural purposes, including for the assessment and collection of tax liabilities of the subsidiary for a taxable period for which it was treated as a separate corporation. Thus, when 100 percent of the equity of a mortgage-backed securities issuer that is a TMP is acquired by a REIT, the issuer, and not the REIT, will be liable for the entity-level taxes imposed on the issuer for the time when it was a stand-alone TMP. Similar rules were adopted for disregarded entities under the check-the-box regulations and

15a See section 1(h)(11) of the Code, added by the Jobs and Growth Tax Relief Reconciliation Act,

effective for years 2003 through 2008.

Chapter 10

125

qualified subchapter S subsidiaries. See Treasury Regulation §§ 301.7701-2(c)(2)(iii) and 1.1361-4(a)(6).

For a discussion of Notice 2006-97 providing guidance on the treatment of excess inclusion income of a REIT TMP, see Chapter 9, text at footnote 89b (in this Supplement).

126

Chapter 11 Special Rules for REITs, Financial Institutions, Tax-Exempts, and Dealers

B. REIT Income and Assets Tests and Thrift Assets Test

Add the following new heading at the beginning of Part B:

1. General

Add the following before the last sentence in footnote 2:

Revenue Procedure 2003-65, 2003-32 I.R.B. 336, provides a safe harbor under which a loan from a REIT secured by an interest in a partnership or by the sole membership interest in a disregarded entity (either, an equity interest) which holds real property will be treated as a real estate asset, and the interest on the loan will be treated as interest on an obligation secured by a mortgage on real property or on an interest in real property, for purposes of the REIT rules. Among other requirements, the loan must be nonrecourse, secured only by the equity interest; the lender must have a first priority security interest in the equity interest; upon default, the lender must replace the borrower as the equity owner (and, in the case of a partnership interest, the other partners must have agreed not to unreasonably oppose the admission of the lender as a partner); on the loan commitment date, the issuer of the equity interest must hold real property and the loan must accelerate upon the sale or transfer of the real property; and on each testing date (as described in the revenue procedure), the value of the real property held by the issuer of the equity interest must be at least 85 percent of the value of all of its assets. For earlier private letter rulings addressing the same issue, see P.L.R.s 200226013, 200225034 and 200225033 (each issued March 21, 2002). Cf. Revenue Ruling 77-459, 1977-2 C.B. 239 (loan secured by a beneficial interest in an Illinois land trust, whose only asset consists of real property, is a real estate asset, and interest on the loan is interest on an obligation secured by a mortgage on real property or on an interest in real property, for purposes of the REIT rules). The New York State Bar Association Tax Section has proposed that Revenue Procedure 2003-65 be updated (i) to eliminate certain technical rules which REITs find very difficult, if not impossible, to comply with and which do not advance the policies underlying the REIT provisions and (ii) to modify certain aspects of the revenue procedure that are inconsistent with the REIT rules for loans directly secured by real property. See “NYSBA Members Seek Updated Guidance on Safe Harbor for REIT Loan Treatment,” 2008 Tax Notes Today 89-21.


A bank that holds rights to service mortgages owned by others may not include the mortgages in its loans outstanding for purposes of determining the balance of its bad debt reserve under section 585. See T.A.M. 200439041 (June 16, 2004).



Chapter 11

127

Add the following after the third sentence in footnote 14:

Revenue Procedure 2001-57, 2001-50 I.R.B. 577, allows a RIC holding a partnership interest in a master-feeder structure to look through the partnership to the underlying assets for purposes of applying various RIC assets tests.

Add the following at the end of Part B:

REITs may invest in real property in foreign countries or in debt instruments of foreign issuers. A REIT also may incur indebtedness denominated in foreign currency to facilitate the acquisition of loans denominated in a foreign currency or non-U.S. real estate assets. The Housing and Economic Recovery Act of 2008,33a enacted on July 30, 2008, provides that foreign currency gains and losses attributable to otherwise qualifying income or to indebtedness incurred by a REIT to acquire non-U.S. loans or assets, are excluded from gross income for purposes of determining whether a REIT satisfies the income tests.33b Accordingly, the income is neutral in applying the income tests. Similar treatment applies to income from hedging transactions entered into to manage currency fluctuations on assets that otherwise produce qualifying income.33c

Prior to enactment of the new REIT provisions, a notice and a revenue ruling, described below, generally provided that currency gains attributable to qualifying income amounts will themselves be qualifying income.33d

Notice 2007-4233e considers a REIT that invests in foreign real estate assets through an entity or partnership that is a qualified business unit (QBU) within the meaning of section 989. In brief, a QBU is a separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records. A QBU can have a functional currency other than that of its owner. In that case, under section 987, income of the QBU is computed in its functional currency, and adjustments are then made when property is remitted from the QBU to its owner to account for foreign exchange gains and losses with respect to accumulated earnings and capital invested in the QBU. Proposed regulations were issued under section 987 on September 7, 2006. Proposed Regulation § 1.987-6(b) provides that the character of section 987 gains or losses is determined by looking to the types of income that the QBU’s assets would produce. By their terms, the proposed regulations would not apply to REITs. Notice 2007-42 allows REITs to follow the look-through-to-assets approach in the proposed regulations pending further notice.

Revenue Ruling 2007-3333f considers a REIT that earns rents and holds mortgages denominated in a foreign currency. Those assets are not held through a QBU, so that foreign exchange gains and losses are accounted for under section 988. The ruling holds that section 988

33a P.L. 110-289 (H.R. 3221) (July 30, 2008). 33b Section 856(n). 33c Section 856(c)(5)(G)(ii). 33d P.L.R. 200808024 (February 22, 2008) reached a similar result with respect to foreign currency

gains on obligations of a REIT used to finance the acquisition of assets that generate qualifying REIT income.

33e 2007-21 I.R.B. 1288. 33f 2007-21 I.R.B. 1281.

Chapter 11

128

foreign currency gain recognized with respect to income of a REIT qualifies as good income for purposes of the REIT income tests to the same extent as the related income.

2. Uses of REIT Subsidiaries

In general terms, stock and the income therefrom are not good real estate assets or real estate income for purposes of the REIT income and assets test, unless the issuing corporation is another REIT. Further, there are limits on how much stock in any non-REIT corporation a REIT can own (generally not more than 10 percent of the securities of an issuer by vote or value, and not more than 5 percent of the assets of the REIT). However, exceptions to these rules apply to qualified REIT subsidiaries and taxable REIT subsidiaries. Those exceptions can be useful in structuring REIT ownership of securitization vehicles.

Under section 856(i)(1), a corporation which is a qualified REIT subsidiary is generally not treated as a separate corporation. Instead, the subsidiary’s assets, liabilities and tax items are attributed to the REIT. Accordingly, the REIT assets and income tests are applied as if the assets and income of the qualified REIT subsidiary were assets and income of the REIT and the subsidiary stock did not exist as a separate asset. A qualified REIT subsidiary is defined in section 856(i)(2) as any corporation other than a taxable REIT subsidiary if 100 percent of the stock of such corporation is held by the REIT. No election is required and an election out is not allowed.

One type of qualified REIT subsidiary is an unincorporated entity that is treated as a corporation under the TMP rules. Such an entity is turned into a corporation under the TMP rules and is then effectively ignored as a qualified REIT subsidiary. As discussed in Chapter 10, Part D, the REIT and its owners do not get off scot-free, because an excess inclusion taint may attach to income of the REIT shareholders. As noted in Chapter 10, this treatment turns REIT/TMPs into quasi REMICs.

The ownership of economic residual interests in mortgage securitizations through quasi-REMICs has been quite popular. One of the main reasons is that REITs are not allowed to be dealers.33g A REIT that originates mortgages and disposes of them for tax purposes through a REMIC offering could well be considered a dealer, because the sale of REMIC regular interests is considered a sale of the underlying interests in the REMIC. A REIT that originates a loan and then keeps it, by borrowing against it through a qualified REIT subsidiary, is not treated as sellng the loan to a customer (sale to customers is a requirement to be a dealer under the relevant definition).

The definition of qualified REIT subsidiary is not limited to domestic corporations. Accordingly, if a REIT owns all of the equity (as determined for U.S. tax purposes) of an offshore issuer of securities that is otherwise classified as a corporation, the corporation disappears and its assets and liabilities are attributed to the parent REIT. Of course, if the foreign entity is a TMP,

33g Section 857(b)(6) imposes a 100 percent tax on net income from prohibited transactions that

produce gain (prohibited transactions that generate losses are ignored for this purpose). A prohibited transaction is defined as a sale or other disposition of property described in section 1221(a)(1) which is not foreclosure property. This section applies to inventory or other property held primarily for sale to customers in the ordinary course of business. As discussed in the text at footnote 63 below, a mortgage company that originates loans for sale to customers may be a dealer under this definition.

Chapter 11

129

the quasi-REMIC rules apply to carry an excess inclusion taint over to the shareholders of the REIT.

The definition of qualified REIT subsidiary is quite restrictive in that it requires 100 percent equity ownership by one REIT. The REIT rules also allow a REIT to hold up to 20 percent of its assets in the form of securities of one or more taxable REIT subsidiaries.33h Under section 856(l), a taxable REIT subsidiary is defined generally as any corporation (other than a REIT) if the corporation and a REIT jointly elect to have the corporation be treated as a taxable REIT subsidiary. The instructions to Form 8875 (the election form) clarify that a corporation may be a taxable REIT subsidiary of more that one REIT. However, each REIT must file a separate Form 8875. In addition, a taxable REIT subsidiary includes any corporation, more than 35 percent of the securities of which (by vote or value), is owned by another taxable REIT subsidiary.33i

The basic idea behind the taxable REIT subsidiary rules is to allow a REIT to engage in certain activities it could not perform directly (such as managing properties or performing noncustomary tenant services) through subsidiaries that are subject to tax.33j Oddly enough, however, the definition does not actually require that a “taxable” REIT subsidiary be taxable; specifically it need not be a domestic corporation that is subject to U.S. federal income tax (but only a corporation other than a REIT). Accordingly, an offshore corporation that is used in a securitization and is not subject to U.S. tax could be a taxable REIT subsidiary. For a discussion of offshore issuers, see Chapter 13.

C. Tax-Exempt Organizations


Section 512(b)(1) also covers substitute dividends or interest and other payments made with respect to a securities loan (as defined in section 512(a)(5)). In P.L.R. 200220028 (October 24, 2001), the Service ruled that this exception applied to fees paid as consideration for entering into an exclusive securities lending agreement.


33h See section 856(c)(4)(B)(ii). Ownership of interests in taxable REIT subsidiaries is further

constrained by the fact that securities of a taxable REIT subsidiary and the income therefrom are not good assets or income for purposes of the 75 percent real property assets and income tests. Normally, a REIT is not allowed to own securities of any one issuer representing more than 5 percent of the value of the REIT’s total assets or 10 percent of the outstanding securities of any one issuer (by vote or value). See section 856(c)(4)(B)(iii). These limitations do not apply to a taxable REIT subsidiary.

33i The definition excludes corporations which operate or manage a lodging facility or health care facility or which provide a brand name under which a lodging facility or health care facility are operated.

33j To protect the tax base, a taxable REIT subsidiary is subject to rules designed to prevent its income from being reduced through excessive payments to its REIT parent. See sections 163(j)(3)(C) (applies earning stripping limits on interest deductions to interest paid to REIT) and 857(b)(7) (REIT subject to 100 percent excise tax on certain deductible payments made by a taxable REIT subsidiary to the REIT parent that are redetermined as being in excess of arm’s length amounts).

Chapter 11

130

Although unlikely, it is possible that a tax-exempt investor holding a subordinated pass-through certificate would be considered to earn a guarantee fee that is treated as UBTI. See Chapter 5, Part B.3.

E. Debt Instruments Held by Banks and Thrift Institutions

Add the following at the end of the carryover paragraph on page 704:

Ordinary treatment of debt instruments under section 582(c) should extend to gains and losses from options on debt instruments.46a



Replace the last two sentences of footnote 54 with the following:

The same rule was extended in 2002 to a foreign bank that would be a bank under section 581 if it were not a foreign corporation. See T.D. 9012 (July 31, 2002), effective for taxable years beginning after January 12, 2001. T.D. 9012 clarifies that the “special rules applicable to banks” include not only the Code but also regulations or other guidance published under the Code. It also describes certain rules tied to the assets of banks (e.g., allocations of interest under Treasury Regulation § 1.882-5) that are not considered special rules applicable to banks on the ground that the rules do not distinguish between banking and non-banking assets. This logic might apply to make section 582(c) (ordinary income and loss treatment for gains and losses of debt instruments held by financial institutions) not a special rule applicable to banks because it applies to debt instruments held by banks, whether or not in connection with banking activities. See, however, the discussion in footnote 55, below. The same logic might also suggest that section 265(b) (pro rata allocation of interest expense to tax-exempt interest) is not a special rule for banks because it does not distinguish banking from non-banking holdings of municipal bonds.

The last paragraph on page 708, including footnote 60, is replaced with the following:

A bank or thrift that is a cash method taxpayer is not required to accrue discount on short-term loans it originates.60

46a See Chapter 8, Part H.3 (in this Supplement). 60 Security Bank Minnesota v. Comm’r, 994 F.2d 432 (8th Cir. 1993), aff’g 98 T.C. 33 (1992). (For

similar cases, see Chapter 4, footnote 309.) The Service did not acquiesce in Security Bank Minnesota when it first was decided and did not follow it in other circuits. After multiple losses, however, the Service finally acquiesced in a similar case in 2001. See 2001-1 C.B. xix (acquiescence in Security State Bank v. Comm’r, 214 F.3d 1254 (10th Cir. 2000)); Revenue Procedure 2001-25, 2001-12 I.R.B. 913 (guidance on automatic consent for cash method banks to change to cash method of accounting for interest on short term loans).

Chapter 11

131

F. Mark-to-Market Rules for Securities Dealers

1. Overview


For a more detailed discussion of the mark-to-market rules for dealers in securities, see Caginalp, Connors, and Handler, B.N.A. Tax Management Portfolio, The Mark-To-Market Rules of Section 475.

In Bank One v. Comm’r, 120 T.C. 174 (2003), the Tax Court rejected the taxpayer’s method of valuing derivatives under section 475 based on the specific facts, but upheld parts of the taxpayer’s methodology (specifically, use of a mid-market valuation with certain adjustments). The case was later reversed as discussed below. On the day the Tax Court case was decided, the IRS, responding to an industry request, issued Announcement 2003-35, 2003-1 C.B. 956, indicating the government is considering proposed regulations allowing the use of financial statement valuations for purposes of section 475 if certain conditions are met. For a discussion of the case and announcement, see William L. McRae, “Financial Modeling from the Bench: Bank One and the Internal Revenue Service’s Attempt to Fix the Consequences,” Journal of Taxation and Regulation of Financial Instruments, Vol. 17, No. 2, 19 (November/December 2003); New York State Bar Association, Tax Section, “Report on IRS Announcement 2003-35,” 2003 Tax Notes Today 197-18; and Edward D. Kleinbard, “Some Thoughts on Market Valuation of Derivatives,” 91 Tax Notes 1173 (May 14, 2001), commenting on pending case.

On August 9, 2006, in a mercifully brief decision, an appellate court reversed the Tax Court decision in Bank One on the ground that once the Tax Court had rejected the bank’s method of valuing its interest swaps, it was required, under section 446, to defer to the IRS’s valuation method unless it was clearly unlawful or plainly arbitrary. The case was remanded for the Tax Court to conduct the proper analysis under the arbitrary and unlawful standard. The appellate court noted that the case was unlikely to have much precedential value given the pending project to conform tax and book valuations. See JP Morgan Chase & Co., as successor to Bank One v. Comm’r, 2006 USTC Par. 50,453 (CCH) (7th Cir. 2006).

On May 20, 2005, the IRS issued Proposed Regulation § 1.475(a)-4, which provides a safe harbor rule allowing taxpayers to elect to use the values of positions reported on certain financial statements as the fair market values of those positions for purposes of section 475. Those regulations were adopted as final regulations by T.D. 9328 in June 2007, effective for taxable years ending on or after June 12, 2007.

In very general terms, the safe harbor permits a dealer in securities (or commodities), but not an electing trader, to elect to have the values that are reported for “eligible positions” on certain financial statements be treated as the fair market values of those positions for purposes of section 475. Once an election is made it may not be revoked without the consent of the IRS. The regulations do not provide a definition of eligible positions but instead provide that the term will be defined in a Revenue Procedure that may be updated periodically as financial markets and products evolve. Revenue Procedure 2007-41, 2007-26 I.R.B. 1492, provides that securities and commodities as described in sections 475(c)(2) and 475(e)(2), respectively, are treated as eligible positions for purposes of the safe harbor. Regardless of whether a position is an eligible position generally, the safe harbor applies only for positions that, taking into account any elections and identifications that are in effect, are required to be marked to market. Thus, for example, if a security is not marked to market because it has been identified as held for investment, then it may

Chapter 11

132

not be marked to market for federal income tax purposes even though the safe harbor election is in effect and the security is properly marked to market on the dealer’s financial statements. Similarly, the fact that a security is not marked to market on the applicable financial statement does not prevent section 475(a) from applying to require that the security be marked to market for tax purposes.

There are four central requirements for a financial accounting method to be eligible for the safe harbor. First, the method must mark eligible positions to market through valuations made as of the last business day of each taxable year. Second, it must recognize into income on the income statement (and not merely on a balance sheet) any gain or loss from marking eligible positions to market. Third, it must recognize into income on the income statement (and not merely a balance sheet) any gain or loss on disposition of an eligible position as if a year-end mark occurred immediately before the disposition. Fourth, it must arrive at fair value in accordance with U.S. GAAP. (The preamble indicates that the IRS and Treasury Department are interested in expanding the scope of the regulations so that they may apply in the future to foreign banks, which typically do not use US GAAP, and it raises several questions the answers to which may facilitate efforts to achieve that expansion.)

In addition to these four requirements, other limitations apply. One important one is that except with respect to eligible positions that are traded on a qualified board or exchange (or other eligible positions designated by the Service), the financial accounting method must not, other than on a de minimis portion of a taxpayer’s positions, result in values at or near the bid or ask values, even if the use of those values is permissible under GAAP. A method meets this test if it consistently produces values nearer to mid-market than to bid or ask values. This rule has the effect of requiring a derivatives dealer that enters into offsetting positions that result in a stream of future net payments representing the dealer’s profit to include the present value of the profit in income when the position is entered into.

A valuation method may account (without duplication) for appropriate costs and risks such as credit risk, future administrative costs and model risk, provided the adjustments are also made in the taxpayer’s financial statements.

The final regulations provide that the election to use the safe harbor is made by filing a statement with the taxpayer’s return declaring that the taxpayer makes the safe harbor election for all eligible positions for which it has an eligible method.

Not all financial statements qualify under the safe harbor. To qualify under the safe harbor, a taxpayer’s financial statement must be described in one of the three following categories, provided that, if the statement is described in (ii) or (iii) below, such statement also must meet the requirements for “significant business use” as described in Treasury Regulation § 1.475(a)-4(j):

(i) A financial statement that is prepared in accordance with U.S. GAAP and that is required to be filed with the SEC;

(ii) A financial statement that is prepared in accordance with U.S. GAAP and that is

required to be provided to the Federal government or any of its agencies other than the Service; or

(iii) A certified audited financial statement that is prepared in accordance with U.S. GAAP; that is given to creditors for purposes of making lending decisions, given to equity holders for purposes of evaluating their investment in the eligible

Chapter 11

133

taxpayer, or provided for other substantial non-tax purposes; and that the taxpayer reasonably anticipates will be directly relied on for the purposes for which it was given or provided.

If a taxpayer prepares more than one type of financial statement that satisfies the

requirements described above, the financial statement that is first described in the list above must be used for purposes of the safe harbor valuation. If a taxpayer has two or more statements of equal priority, then the statement that provides the highest aggregate valuation is required to be used. If the taxpayer has no statement that qualifies, it may not use the safe harbor.

Replace the last sentence of footnote 61 with the following:

Taxpayers seeking to make these elections must pay close attention to the calendar. Under Revenue Procedure 99-17, 1999-1 C.B. 503 (section 6 superseded by Revenue Procedure 99-49, 1999-2 C.B. 725, which was clarified, modified, amplified and superseded by Revenue Procedure 2002-9, 2002-1 C.B. 327), absent the consent of the IRS, elections under section 475(e) for dealers in commodities and under section 475(f) for traders in securities or commodities are effective for a taxable year only if the taxpayer files a specified statement with its original federal income tax return for the prior taxable year (or with a request for an extension of time to file that return) not later than the due date (without regard to extensions) of such return. A new taxpayer makes the election by placing the specified statement in its books and records no later than 2 months and 15 days after the first day of the election year and must attach a copy of the statement to its original federal income tax return for the election year. In P.L.R. 200429011 (April 8, 2004), the IRS declined to provide an extension of time for a taxpayer to make an election under section 475(f). Under Revenue Procedure 99-17, once made, the election may not be revoked without the consent of the IRS. See also H.R. Rep. No. 148, 105th Cong., 1st Sess. (1997). The 2006-2007 IRS Business Plan included “[f]inal regulations under section 475(e) and (f).” This item was also included in the 2005-2006 and 2004-2005 IRS Business Plans. However, this item was not included in business plans subsequent to the 2006-2007 IRS Business Plan. The section 475(e) and (f) elective regimes do not seem to raise special issues in the securitization area and are not considered further here.

2. Definition of Dealer


In T.A.M. 200120001 (July 28, 2000), the IRS held that a taxpayer who purchased consumer automobile loans from automobile dealers was a securities dealer under the general definition, but fell within the negligible sales exception described below in the text.

4. Exceptions to Mark-to-Market Requirement


See footnote 119a, below (in this Supplement) for discussion of a Chief Counsel Advice that rejected a taxpayer argument that securities that were once identified as held for investment under section 475(b)(1)(A) were “held primarily for sale to customers” so that they could prospectively be marked to market.


Chapter 11

134

Chief Counsel Advice 200731029 (April 26, 2007) concludes that mortgage loans were properly identified as held for investment where the taxpayer had made a blanket identification of “RE loans-held for sale” and then used a software program that was not part of its general ledger to track loans held for sale. The standard was whether the identification was reasonable, and the CCA concludes that it was.

5. Treatment of Gains and Losses

Add the following after the first bullet point on page 728

• Securities that were properly identified as held for investment or otherwise eligible for an exception from mark-to-market treatment under section 475(b)(2) but cease to be eligible for the exception are subject to mark-to-market treatment for changes in value following such cessation.119a

119a See section 475(b)(3). Chief Counsel Advice 200817035 concludes that a taxpayer that was a

dealer in securities within the meaning of section 475 and had properly identified certain securities as held for investment when acquired under section 475(b)(1)(A) had not established that its purpose had changed to holding the securities primarily for sale to customers in the ordinary course of business so that it could prospectively mark the securities to market. The taxpayer argued that its business plan had changed as evidenced by an accounting reclassification of the securities as held for sale and a pattern of greater sales made in response to a direction by a regulator to sell securities to raise capital. The taxpayer also argued that it had adopted a plan of selling opportunistically to increase income. The CCA showed statements in taxpayer documents supporting the view that the taxpayer’s motive had not changed and dismissed greater sales resulting from a need to raise capital as a ground for meeting the held primarily for sale test. That test was not met, and the taxpayer was acting as an investor, when it held assets for the income generated while held rather than to generate a merchandising profit. The CCA states that regulations under section 475 did not change the test of dealer status to one requiring only regular sales. The CCA indicates that the fact that the taxpayer was selling to dealers undercut the argument that it was selling to customers.

135

Chapter 12 Taxation of Foreign Investors

B. TEFRA Registration Requirements

1. Overview

Add the following at the end of footnote 4.

Notice 2006-99, 2006-46 I.R.B. 907, clarifies that bonds are considered to be in registered form if they are required to be held through a book-entry system maintained by a clearing organization even if holders can obtain physical certificates in bearer form in extraordinary circumstances that are unlikely to occur (specifically, the clearing organization going out of business without appointment of a successor). The Notice provides a grandfather rule allowing outstanding debt that was issued before January 1, 2007 under the TEFRA D rules to continue to be treated as in bearer form until the paper matures, notwithstanding that it must in the future be held through such a book-entry system. The TEFRA D rules are procedures for qualifying for the Eurobond exception set forth in Treasury Regulation § 1.163-5(c)(2)(i)(D). See footnote 11, below, and the accompanying text. This Notice was adopted in response to developments in Japan. The Notice also announces the demise of the special rules for foreign targeted registered obligations in Treasury Regulation § 1.871-14(e). The change is generally effective for debt issued after December 31, 2006, with a two-year transition period for debt having a term of no more than 10 years.

2. Asset-Backed Securities

For a more detailed description of those withholding tax rules, see Connors, “Non-Resident Alien Withholding,” 13 Tax Strategies for Corporate Acquisitions, Dispositions, Spin-offs, Joint Ventures, Financings, Reorganizations, and Restructurings, Practising Law Institute (2002).

C. Withholding Tax

1. Overview

Add the following new footnote 29a at the end of the first sentence of the first full paragraph on page 742:

Effective for dividends with respect to taxable years of RICs beginning after December 31, 2004, and before January 1, 2008, sections 871(k) and 881(e), enacted by AJCA 2004, permit a RIC, such as a money market fund, to designate all or a portion of a dividend as an “interest-related dividend” and/or a “short-term capital gain dividend” to the extent sourced out of appropriate income by written notice mailed to its shareholders not later than 60 days after the close of its taxable year; and (with very limited exceptions) those dividends received by a foreign person will be exempt from withholding tax. The related House bill did not include a sunset provision and it is unclear why one was included in the Act, as passed. The 2004-2005 IRS Business Plan had included “[g]uidance under the American Jobs Creation Act of 2004 regarding

Chapter 12

136

the treatment of certain RIC dividends for withholding tax purposes.” However, this item was not included in subsequent business plans, so it appears the project has been dropped.


AJCA 2004 added section 861(a)(1)(C) providing that interest paid by a domestic resident foreign partnership is not considered to be derived from U.S. sources if the partnership is predominantly engaged in the active conduct of a trade or business outside the United States and the interest is not paid by a trade or business engaged in by the partnership in the United States and not allocable to income which is effectively connected (or treated as effectively connected) with the conduct of a trade or business in the United States.

Revise the discussion of the source rule for REMIC residual interests in the text at footnote 34 and in footnote 34:

Effective for taxable years ending after August 1, 2006, Treasury Regulation § 1.863-1(e)(2) provides that excess inclusion income from a REMIC residual interest shall be treated as income from sources within the United States. A net loss from holding a residual interest will be allocated to the same class of gross income (e.g., U.S. source) as excess inclusion income from the residual interest to the extent the net loss does not exceed the excess inclusion income previously taken into account with respect to the residual interest. This rule does not seem appropriate to the extent the underlying income of the REMIC is derived from foreign sources, but is justified in the preamble on the ground that the income is a creature of U.S. tax law and unlikely to have tax significance outside of the United States. The regulation could also change foreign tax credit limitation calculations under section 904 for U.S. taxpayers holding residual interests in REMICs holding foreign mortgages. Note that the rule does not grandfather outstanding REMICs. Also, the rule applies to excess inclusion income, not all income, from a REMIC residual interest, so the discussion in the text and in footnote 34 would continue to be relevant for non-excess inclusion income.

Add the following comment relating to footnote 38 and the accompanying text:

In light of the regulation discussed immediately above (in this Supplement) treating excess inclusion income as domestic source, the cases where income from a REMIC residual interest is foreign source will be very unusual indeed (foreign assets and income that is not an excess inclusion).

Add the following comment to the text on page 746 at footnotes 40 and 41:

On July 14, 2008, the IRS issued final regulations requiring income on residual interests to be taken into account earlier than at the time of payment or disposition for purposes of applying withholding tax rules. The preamble to the regulations indicates that they are aimed at transactions in which a residual interest is transferred to a domestic partnership with no foreign partners and foreign partners are later admitted. The goal of the transaction is to allocate some share of the excess inclusion income to the newly admitted partners without incurring any obligation to pay withholding tax until payments are made on the residual interests (which may never happen) or until there is a disposition of the foreign holder’s interest in the residual interest. For a discussion of other (successful) efforts of the IRS to combat transactions of this type, see Chapter 9, Part E.4.e.(ii) (in this Supplement). The regulations were adopted as final regulations without change by T.D. 9415.

Chapter 12

137

The regulations add a new section 1.860G-3(b) (reproduced in Appendix C in this Supplement). It requires that a domestic partnership account separately for foreign partners’ shares of taxable income or loss from a REMIC residual interest (not just excess inclusion income) and that the amount allocated to a foreign partner be taken into account by the foreign partner, for purposes of the rules governing withholding on income payments to foreign persons, as if that amount were received on the last day of the partnership’s taxable year, except to the extent the amount is required to be taken into account earlier due to a distribution to the foreign partner or a reduction in the foreign partner’s indirect interest in the REMIC residual interest. The regulations also provide that for purposes of the withholding tax rules, any amount of income allocated to a foreign person owning an interest in a pass-thru entity (a RIC, REIT, common trust fund, or a subchapter T cooperative) and treated as excess inclusion income under section 860E(d)(2) (discussed in Chapter 9, Part E.4.c) will be taken into account at the same time as other income. This result would likely happen anyway, so this second rule may be seen as a precautionary move. These new provisions apply to net income of a foreign person from a residual interest if the first net income allocation to the foreign person under section 860C(a)(1) (the section allocating REMIC net income to a holder on a daily basis) occurs on or after August 1, 2006.

Applying the regulations governing tax withholding by domestic partnerships (specifically section 1.1441-5(b)(2)), the practical effect of the foregoing REMIC partnership rule is that a domestic partnership allocating REMIC residual income to a foreign partner will be required to withhold on the income (1) when making current distributions that include amounts subject to withholding, or (2) to the extent there has not already been withholding because of distributions, on the earlier of the date when a Schedule K-1 is mailed to the foreign partner or the due date for furnishing the K-1 to the partner.

Just to make sure no one has missed the point that the IRS wants tax to be withheld, the same regulation package adds a new section 1.1441-2(d)(4). It eliminates the exemption in section 1.1441-2(d) with respect to amounts described in section 1.860G-3(b)(1) (allocations by a domestic partnership of income from a REMIC residual interest to a foreign partner). The paragraph 2(d) exemption normally relieves a withholding agent of liability to withhold where the agent is unrelated to a foreign recipient of income and either lacks control over or custody of money or property from which to withhold or lacks knowledge of facts giving rise to the payment. Thus, it is abundantly clear that a partnership with foreign partners would be required to withhold tax on such income even if the REMIC residual interest never produces a dime of cash. The change is effective for payments made after August 1, 2006.

2. Portfolio Interest Exemption

Treasury Regulation § 1.871-14(g), finalized on April 12, 2007 (T.D. 9323, F.R. 18386), applies the 10-percent shareholder exception described in footnote 45 to the definition of portfolio interest at the partner or trust owner level, and not to the partnership or trust. To illustrate when this makes a difference, suppose that a partnership holding 15 percent of the stock of a domestic corporation also receives interest on a debt obligation of the corporation. The partnership has a foreign partner, FP, who has a 50 percent pro rata share of all partnership items and otherwise has no interest in the stock of the corporation. If the exception were applied at the partnership level, then the interest allocated to FP would not be portfolio interest because FP owns more than 10 percent of the debtor corporation. By contrast, if the test were applied at the partner level (the approach taken in the regulations), the interest allocated to FP would be

Chapter 12

138

portfolio interest because FP has (by attribution) only a 7.5 percent stock ownership interest in the corporation. The regulations are effective for interest paid to a partnership after April 12, 2007 (although taxpayers may elect to apply them, consistently, to prior open years). The application of the 10-percent shareholder test to partnerships was discussed in the NYSBA Reforms Report.

A committee of the American Bar Association has submitted to the IRS an extensive analysis of issues arising under the portfolio interest exemption and related TEFRA registration issues, together with related recommendations. The report discusses some issues relevant to securitizations. See 2004 Tax Notes Today 54-20 (March 18, 2004).


Although unlikely, it is possible that a foreign investor holding a subordinated pass-through certificate would be considered to earn a guarantee fee that is treated as non-interest FDAP income from U.S. sources (to the extent the underlying trust assets are debt obligations of U.S. residents).60a


Temporary regulations with respect to withholding obligations of domestic partnerships that allocate income from REMIC residual interests to foreign partners were issued on July 31, 2006. These regulations were finalized on July 14, 2008 without substantial changes and are discussed at Chapter 12, Part C.1 (in this Supplement).

3. Income from Swaps, Rents, and Options

Revise heading to “Income from Swaps, Rents, Options and Fees”

a. Swaps.

In the sentence that ends with footnote 63 on page 755, replace the word “rarely” with “never,” and revise footnote 63 to read as follows:

Treasury Regulation 1.863-7(b). Under this regulation, income of a non-U.S. person would be sourced in the United States if it were effectively connected with a U.S. trade or business, but in that case there also would be no withholding (as least if a Form W-8ECI were provided). In light of the fact that withholding can never apply as a substantive matter to swap payments, Treasury Regulation § 1.1441-4(a)(3) exempts withholding agents from any obligation to withhold on notional principal contract payments, regardless of whether a withholding certificate is provided. The withholding agent does, however, have an obligation to report payments that are effectively connected with a U.S. trade or business (and the regulations have rules for demonstrating that income is not ECI). The special withholding tax rule for notional principal contract payments does not apply to amounts treated as interest under the rules for significant nonperiodic payments in Treasury Regulation § 1.446-3(g)(4) (see Chapter 8 at footnote 236).


60a See Chapter 5, Part B.3 (in book and in this Supplement).

Chapter 12

139

As discussed in Chapter 2, Part H, and Chapter 8, Part H.3.a (each in this Supplement), there has been some debate under current law whether default swaps and PAYGO swaps should be characterized as (1) NPCs or options, payments on which generally would not be subject to withholding tax, or (2) possibly, as some other type of financial contract payments on which might be subject to withholding tax. The consensus view has been that the first characterization is correct provided the swap documentation does not require the protection buyer to suffer an actual loss as a condition for payment from the protection seller. The 2008-2009 IRS Business Plan lists “[g]uidance under section 1441 on qualified intermediaries and other withholding issues” as a project the IRS expects to complete in the plan year ending June 30, 2009. Announcement 2008-98, 2008-44 I.R.B. 1082, announces changes in the qualified intermediary agreement and auditing requirements aimed at improving compliance (in response to reports of compliance failures by certain foreign banks). The 2007-2008 IRS Business Plan had included “[g]uidance on documentation, securities lending, and other withholding issues under section 1441” and the 2006-2007 and 2005-2006 IRS Business Plans had included “[g]uidance on securities lending, the treatment of certain financial products, and other withholding tax guidance.” The 2004-2005 Business Plan had included “[g]uidance on the treatment of certain financial products for withholding purposes.”

Add the following new section d. at the end of Part C.3.:

d. Fees. Income from fees charged to borrowers generally would be FDAP income, and may or may not qualify as interest that might qualify for the portfolio interest exemption depending on the nature of the fee. Commitment fees might not be FDAP income on the ground that they are analogous to option premiums, but the point is not clear.70a The IRS has recently clarified that fees paid by credit card debtors to credit card issuers for late payments qualify as interest. On the other hand, annual fees represent services income that would be FDAP income and not qualify as interest.70b

4. Withholding Agents

In Notice 2002-41, 2002-24 I.R.B. 1153, the IRS proposed guidance for simplifying certain withholding tax rules for foreign partnerships and foreign simple and grantor trusts. The proposed guidance would permit a foreign partnership or trust to enter into an agreement with the IRS to become a “withholding partnership” or “withholding trust.” In that case, with respect to direct owners of equity interests in the partnership or trust (or other withholding partnerships or trusts, but not other intermediaries), the partnership or trust would not act as a pass-through entity, passing through to withholding agents forms W-8 or W-9 it receives from partners or beneficiaries. Instead, the partnership or trust would be responsible for obtaining the forms and withholding taxes from the partners or beneficiaries (and paying over any withheld taxes to the IRS). For further guidance on this topic, see Revenue Procedure 2003-64, 2003-32 I.R.B. 306.

70a See Chapter 13, footnote 99 and accompanying text. 70b See Chapter 8, Part G.2 (in this Supplement).

140

Chapter 13 Offshore Issuers A. Introduction

Add the following after the fifth sentence of footnote 9:

Compare IRS private letter rulings discussed in Chapter 4, footnote 37a (in this Supplement), which held that nominal interests in an LLC that were created solely to create “bankruptcy remoteness” and provided for no economic interest (or significant management rights) could be ignored in classifying the LLC.


Regulations have been adopted under section 269B. See T.D. 9216, 2006-36 I.R.B. 461. They do not specifically address the treatment of debt co-issuers.

B. Definition of Foreign Corporation

Replace the citation to Revenue Ruling 88-25 in footnote 10 with the following:

Treasury Regulation § 301.7701-5 confirms this result. See also Revenue Ruling 88-25, 1988-1 C.B. 116. Treasury Regulation § 301.7701-2(b)(9) has a more controversial rule that classifies a dual-chartered entity as a corporation if it would be so classified under the laws of any jurisdiction in which it is organized. For example, under these regulations, a Delaware limited liability company that is also chartered as a public limited company in the U.K. (a type of per se corporation under the check-the-box regulations) will be classified as a domestic corporation (domestic because of its status as a Delaware LLC and a corporation because of its status as an English plc). The foregoing regulations were adopted as final regulations by T.D. 9246 in January 2006 and replaced temporary regulations issued in August 2004. The final regulations generally apply as of August 12, 2004 to entities in existence on or after that date, but apply to entities created or organized under the laws of more than one jurisdiction as of August 12, 2004 only as of May 1, 2006, unless they choose to rely on the new rules as of August 12 2004.

Add the following at the end of the first full paragraph on page 767:

An entity that otherwise would be a foreign corporation may be classified as a domestic corporation under new section 7874, introduced by AJCA 2004, if it is a successor to a domestic corporation or partnership in certain inversion transactions.10a

10a See section 7874(b). The section would apply to a foreign corporation that completes after March

4, 2003 the acquisition of substantially all of the properties held directly or indirectly by a domestic corporation, or substantially all of the properties constituting a trade or business of a domestic partnership, if after the acquisition at least 80 percent of the stock by vote or value of the foreign corporation is held by former equity holders of the corporation or partnership by reason of owning equity in the corporation or partnership, and the group including the foreign corporation does not have substantial business activities in the foreign country in which the foreign

Chapter 13

141

D. Taxation of Effectively Connected Income


The requirement of timely filing can be waived in some circumstances by the Service. The relevant standard for granting waivers was loosened, effective March 10, 2003, to make it easier for taxpayers who were not aware of the filing requirement and, otherwise, acted reasonably and in good faith to obtain relief. See Treasury Regulation §§ 1.874-1 and 1.882-4.

Add the following after the fourth sentence in footnote 17:

Treasury Regulation § 1.882-4 was amended, effective March 10, 2003, to provide that a foreign corporation’s deductions will not be disallowed for failure to file a return (or protective return) if the foreign corporation can establish that, based on the facts and circumstances, in failing to file it acted reasonably and in good faith. The regulation lists a number of factors that are to be considered in determining whether the corporation acted reasonably and in good faith, including “[w]hether the corporation failed to file a U.S. income tax return because, after exercising reasonable diligence (taking into account its relevant experience and level of sophistication), the corporation was unaware of the necessity for filing the return.” Treasury Regulation § 1.882-4(a)(3)(ii)(D). An example indicates that a corporation would not be eligible for relief if it was advised by a tax advisor that whether U.S. income tax returns for those years were necessary was unclear and that it could file a protective return but chose not to do so. Treasury Regulation § 1.882-4(a)(3)(iii), Example 3. In Notice 2003-38, 2003-27 I.R.B. 9 (issued July 7, 2003), the IRS announced that it would waive filing deadlines for nonresident aliens and foreign corporations that filed on or before September 15, 2003 all required U.S. federal income tax returns (not including protective returns) for every year for which a waiver was requested, paid the reported income tax liability with each such return (together with interest and certain penalties) and met certain other requirements. In Swallows Holdings v. Comm’r, 515 F.3d 162 (3rd Cir. 2008), reversing Swallows Holding Ltd. v. Comm’r, 126 T.C. 96 (2006), the Third Circuit overturned a Tax Court decision, which held that regulations denying deductions to a foreign corporation that filed a tax return late were invalid because section 882(c)(2) does not impose a timely filing requirement. The Third Circuit held that the adoption of the 18-month timely filing requirement in Treasury Regulation § 1.882-4(a)(3)(i) was a reasonable exercise of the Treasury’s authority. The court stated that the reasonableness of the regulation should have been tested under the factors set forth in Chevron U.S.A., Inc. v. National Resources Defense Council, Inc., 467 U.S. 837 (1984), rather than those set forth in National Muffler Dealers Association v. United States, 440 U.S. 472 (1979). Under the Chevron analysis, the Third Circuit determined that the statutory language of section 882(c)(2) was not clear and unambiguous (specifically, whether the word “manner” includes a timing requirement). Given that “manner” has been used in certain provisions to include a timing element and not in others, Treasury was justified in promulgating regulations to prescribe a timing element. The court indicated that the Treasury was due some deference in light of the highly technical and complex scheme of the Code. For a two-part article discussing the case and arguing, prior to its appeal, that it should be overturned on appeal, see Steve R. Johnson, “Swallows Holding as It Is: The Distortion of National Muffler,” 112 Tax

corporation is organized when compared to the total business activities of such group. The IRS has issued two sets of temporary regulation applying section 7874. See T.D. 9238, 2006-6 I.R.B. 408 (Feb. 6, 2006) (deals with technical issues in applying the inversion rules to transactions within a group), and T.D. 9265, 2006-27 I.R.B. 47 (applies substantial business activities test, among other things).

Chapter 13

142

Notes 351 (July 10, 2006), and “Swallows as it Might Have Been: Regulations Revising Case Law,” 112 Tax Notes 773 (July 28, 2006). For a critical analysis of the Third Circuit opinion, see “The Validity of Tax Regulations—the Third Curcuit Adrift,” by Vorris J. Bankenship, 2008 Tax Notes Today 209-25 (October 28, 2008).


Under section 884(e)(3), no withholding tax is imposed on dividends paid by the foreign corporation out of the same earnings and profits.

Add the following at the end of the first paragraph on page 771:

Dividends paid by a foreign corporation out of earnings and profits for a taxable year in which it was subject to the branch profits tax are not subject to U.S. withholding tax.19a

1. Trade or Business – Common Law Definition


For a discussion of a recent case holding than an individual was not a securities trader unless he engaged in trading activity over an extended period, see Chapter 4, Part F.3.b.(i) (in this Supplement). Caution should be taken in applying this principle to a legal entity whose principal activity is investing or trading in securities.

2. Securities Trading Safe Harbor


F.S.A. 200224003 (June 14, 2002) concludes that a foreign corporation that factors receivables for a domestic subsidiary cannot rely on the securities trading safe harbor (because it is not trading securities). However, the advice concludes that the factoring activity was an investment activity that did not cause the parent to be engaged in a U.S. trade or business.

3. Special Topics

b. Loan Origination

The 2008-2009 IRS Business Plan lists “[g]uidance on inbound investment, financing, broker, and dealer activities, including further guidance on certain investment income of foreign governments, and on certain lending and securities lending activities” as a project the IRS expects to complete in the plan year ending June 30, 2009. The 2007-2008 IRS Business Plan had included “[g]uidance on financing activities, including lending activities under section 864.” The 2006-2007 IRS Business Plan had included “[g]uidance on lending activities under section 864 and other guidance under section 864.” Apparently, the project listed in the 2007-2008 IRS Business Plan was initiated following inquiries concerning the lending activities of offshore hedge funds.

19a Section 884(e)(3).

Chapter 13

143

The New York City Bar Association submitted a report in response to the Business Plan topic. See New York City Bar, “Report Offering Proposed Guidance Regarding U.S. Federal Income Tax Treatment of Certain Lending Activities Conducted Within the United States,” by the Committee on Taxation of Business Entities, May 3, 2007, 2007 Tax Notes Today 88-51 (May 7, 2007). This is a difficult topic and the report is a good starting point for developing concrete guidance in the area. The cover letter describes the safe harbors as follows:

“In the first of our safe harbor recommendations, we analyze the sometimes fine line between writing a loan, which could give rise to engaging in a trade or business, or purchasing a security, which generally does not. In particular, we focus on a foreign person’s commitment to acquire a loan in the U.S. from a lender before the loan is funded, a ‘forward purchase commitment’. In making our recommendations, we recognize that there are situations involving forward purchase commitments that suggest the lender might be acting as agent for the foreign person (transactions with what we refer to broadly in this report as Lending Affiliates) and we suggest additional requirements to assure that the foreign person’s purchase is in the nature of a secondary market transaction. In the absence of a transaction involving a Lending Affiliate, we propose a safe harbor that would allow a foreign person to purchase a fully funded loan pursuant to a forward purchase commitment without being treated as engaging in a U.S. trade or business. Our proposed safe harbor would apply provided (i) the foreign person was not committed to purchase the loan until after the lender was contractually committed to provide applicable financing, (ii) the foreign person has no understanding with the borrower concerning the loan prior to purchase, (iii) the loan is neither purchased from nor made by an affiliate of the foreign person or of a person that makes investment decisions for the foreign person, (iv) the person making investment decisions for the foreign person in connection with the loan is not affiliated with the person making such decisions for the lender, (v) the loan was made by the lender in the ordinary course of business, and (vi) the loan is not purchased by the foreign person until 24 hours after the loan is closed.

We were unable to offer safe harbors in connection with a purchase of a revolving credit line and a purchase of a loan made by a Lending Affiliate. For these situations, we have proposed guidelines for Treasury consideration identifying the factors that we consider relevant in analyzing whether the transaction warrants treatment as a secondary market transaction.

Our second safe harbor proposes that making a limited number of loans over a specified period should not by itself cause a foreign person to be treated as engaging in a U.S. trade or business. Review of the relevant authorities leads us to recommend that a foreign person can originate up to four loans a year, with a two year lookback, without giving rise to such status, so long as the foreign person does not hold itself out as a lender, and the loans are held for a minimum period of time.

Our third safe harbor recommendation addresses loans that are incidental to the acquisition of equity or equity rights, including a focus on PIPEs. We believe loans should be disregarded for trade or business status if, as part of the transaction, the foreign person acquires stock or related rights to stock in the borrower, there is a minimum holding period for the assets and, based on recognized and contemporaneous financial analysis that the foreign person would need to retain in its files and be able to produce on demand, the foreign person reasonably expects to earn more than 50% of its return from appreciation in the equity component of its investment unit.

Chapter 13

144

Finally, we believe that where the dominant motive of a foreign person is to acquire, protect or enhance a pre-existing investment, whether that investment is debt or equity, the loan should not be considered in determining trade or business status. This is an intent based test that lacks the certainty of our other proposals, but which we believe reaches the correct result.”

As discussed in Chapter 4, Part F.3.b.(i) (in this Supplement), the IRS recently proposed regulations that would change current law and prevent a newly originated loan from being considered an ordinary asset under section 1221(a)(4) on the ground that it represents a receivable arising from providing services to the borrower. The regulation was based on the view that the lender is providing money to the borrower more than a service. While different policies may affect the treatment of an asset as ordinary or capital and the taxation of foreigners engaging in activities in the United States, this regulation could be helpful in arguing that a loan originator is not inherently providing a service to borrowers that amounts to a trade or business just because it makes money directly available to the borrower, as the first lender. Something more is needed. The proposed regulations were quite controversial, however, and were withdrawn. The capital/ ordinary distinction is not relevant to banks because all of their gains or losses from sales of debt instruments are ordinary under section 582(c), discussed in Chapter 11, Part E.

Add the following new section D.3.d. at the end of Part D.3:

d. Foreclosure Property. Where an offshore issuer holds a secured loan, it may acquire the real or personal property securing the loan through foreclosure. That property may be subject to a lease when acquired. In addition, because many types of property, such as commercial real property, are more readily salable when under lease, the offshore issuer may effectively be required to enter into new leases after acquisition in order to conserve the value of the foreclosure property in contemplation of its disposal. While there is no authority on point, any such post-foreclosure leasing activity should be considered an “activity closely related” to the offshore issuer’s business of trading in securities and, thus, should not cause the issuer to be considered to be engaged in a U.S. trade or business even if undertaken in the United States.59a In other contexts, the acquisition and operation of foreclosure property is not considered a trade or business.59b In addition, under general tax principles, the mere ownership of investment property in the United States is not considered a business activity.59c Of course, if the offshore issuer holds and operates the property for more than a reasonable liquidation period or operates the property

59a Of course, rent arising from real or personal property located or used within the United States

generally will be U.S. source FDAP income and thus will be subject to withholding tax. See Chapter 12, Part C.3. Similarly, an offshore issuer owning real property in the United States will be subject to the FIRPTA rules discussed in Chapter 12, Part D.

59b See Chapter 4, footnote 72 and accompanying text (discussion of foreclosure property in the context of fixed investment trusts); see also Chapter 6, Parts B.2.b.(iii) and C.3 (discussion of foreclosure property in the context of REMICs); Treasury Regulation § 301.7701-4(d) (liquidating trusts, including bondholders’ protective committees, are treated as trusts and not associations); Broadway-Brompton Buildings Liquidation Trust v. Comm’r, 34 B.T.A. 1089 (1936) (bondholder protective committee treated as trust even though it operated rental building during liquidation period). Cf. Chapter 7, footnote 34 (discussion of foreclosure property in the context of thrift institutions); sections 856(c)(2)(F) and (c)(3)(F) (allows REIT to treat income from foreclosure property as qualifying income).

59c See footnote 22, above. For many states, however, the mere ownership of property within that state is sufficient to cause a foreign corporation to become subject to state taxation.

Chapter 13

145

other than solely with a view towards selling it promptly (for example, by providing services to lessees) its activities may cause it to be considered to be engaged in a U.S. trade or business.59d

4. Effective-Connection Test

Add the following new footnote 62a at the end of the second full sentence on page 784: A taxpayer that is engaged in the active conduct of a banking, financing or similar business through a U.S. office can also have income from stocks or securities that is effectively connected with a different but related U.S. business such as securities trading. See Treasury Regulation § 1.864-4(c)(5)(vi). Treasury Regulation § 1.864-4(c)(5)(ii) limits the income from certain medium- or long-term corporate debt securities (more specifically, debt instruments with maturities exceeding one year not issued by the U.S. or one of its agencies and not acquired in securities underwriting or lending activities or held as banking reserves) that is considered effectively connected with a banking, financing or similar business to 10 percent of the assets of the taxpayer’s U.S. office (the 10 percent rule). T.A.M. 200811018 (November 29, 2007) applied Treasury Regulation § 1.864-4(c)(5)(vi) to conclude that income from certain securities arbitrage activities of a bank taxpayer that were not ECI under the 10 percent rule could still be treated as ECI under the general asset-use test in Treasury Regulation § 1.864-4(c)(2) or business activities test in Treasury Regulation § 1.864-4(c)(3). The taxpayer was also a dealer in securities and could not avail itself of the securities trading safe harbor under section 864(b)(2)(A)(ii). It was determined, as a factual matter, that the securities were not held for investment. The T.A.M. has a lengthy discussion of that issue, and holds that the fact that the securities were marked to market under section 475 was not determinative of the issue. A companion ruling, T.A.M. 200811019 (November 29, 2007), involved a different issue relating to the 10 percent rule. It held that where a bank owned an interest in a partnership holding securities for investment, the 10 percent rule would be applied on a look-through basis as if the bank owned its share of the partnership assets directly. Further, Treasury Regulation § 1.864-4(c)(5)(vi) did not apply to treat as ECI income from the partnership assets not treated as ECI under the 10 percent rule because the securities were held for investment (and thus not in a trading business). That was true even though they had been held in a trading business by the bank before being transferred to the partnership. The partnership had been formed to raise Tier 1 capital from outside investors.

Replace the third and fourth sentences in footnote 66 with the following:

The term “security” is defined as “any bill, note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in, or right to subscribe to or purchase, any of the foregoing items.” Treasury Regulation § 1.864-4(c)(5)(v). The phrase “evidence of indebtedness” is a general Code term used to refer to all types of debt (see, e.g., section 1275(a)(1)(A)), so the term security should encompass all debt, including loans. Curiously, the court in InverWorld, Inc. v. Comm’r, T.C. Memo 1996-301, 71 T.C.M. (CCH) 3231, supplemented on other grounds, T.C. Memo 1997-226, 73 T.C.M. (CCH) 2777 (see footnote 70, below (in this Supplement)), appears to have assumed that a loan would not be a security (see Part III. B.4.c.(1) of the opinion), but does not discuss why. Treasury Regulation § 1.864-4(c)(5)(vii), Example (1) treats loans as securities. See also Example (5) (which refers to “securities involved in loans” made by a branch).

59d See Chapter 4, footnote 73. See also Jackson v. U.S., 110 F.2d 574 (9th Cir. 1940) (liquidating

trust was taxable as a corporation when its intention to liquidate was incidental to its business activities, rather than the other way around).

Chapter 13

146


In InverWorld, Inc. v. Comm’r, T.C. Memo 1996-301, 71 T.C.M. (CCH) 3231, supplemented on other grounds, T.C. Memo 1997-226, 73 T.C.M. (CCH) 2777, the court did use the definition of independent agent found in Treasury Regulation § 1.864-7 (relating to foreign source income) for purposes of section 864(b)(2)(A)(i) (a safe harbor for foreigners trading in securities through a resident broker or other independent agent), even though such regulation does not by its terms apply to this section. The court applied the regulation because both parties to the case relied on it in their argument and because the regulation construed the phrase “office or other fixed place of business in the United States,” which is also found in section 864(b)(2)(C) (which references section 864(b)(2)(A)(i)). Applying the regulation, the court determined that a domestic indirect subsidiary of a foreign dealer in securities was a dependent agent that regularly contracted on behalf of the foreign dealer, so that the agent’s office could be attributed to the taxpayer. The facts in InverWorld differ from those of a typical offshore issuer, however. Significantly, the domestic subsidiary in InverWorld acted “almost exclusively” for the foreign parent and thus was regarded as an exclusive agent. Under Treasury Regulation § 1.864-7(d)(3)(iii), an exclusive agent that otherwise would qualify as an independent agent may be treated as a dependent agent under the facts and circumstances of the particular case. In contrast, the investment activities of most offshore issuers are managed by professional money management firms that manage investments for a significant number of clients and not just for a single offshore issuer.

E. Withholding Tax

In footnote 89, replace “1988” with “1998.”

Add the following at the end of the carryover paragraph on page 794:

Conventional default swaps should be regarded as notional principal contracts or put options depending on their terms. Accordingly, income from such contracts should be exempt from withholding tax on the ground that income is sourced outside of the United States, in the case of a notional principal contract, or is not FDAP income, in the case of an option.97a


“Facility fees,” fees paid on the entire amount of a revolving credit facility (both drawn and undrawn) were distinguished from commitment fees in T.A.M. 200514020 (December 29, 2004). That T.A.M. held that facility fees were ordinary and necessary business expenses currently deductible under section 162, and were not in the nature of capital expenditures under section 263 97a For a letter to the Treasury describing credit default swaps, discussing their tax treatment and

suggesting confirmation that they are not subject to withholding tax, see letter dated July 2, 2002 from Capitol Tax Partners to Rob Hanson and Barbara Angus, 2002 Tax Notes Today 148-34. The letter argues that a credit swap is distinguishable from a guarantee or insurance on the grounds that the swap contract does not require a loss by the party purchasing protection and does not involve the credit of parties related to the protection seller. Guarantee fees would be FDAP income and potentially subject to withholding tax if the obligor on the guaranteed obligation is a U.S. resident. Payments under an insurance contract relating to U.S. risks would be subject to the excise tax described in footnote 203, below.

In a letter, dated October 24, 2002, to the IRS, ISDA concurred with the Capitol Tax Partners’ suggestion, with minor clarifications. A copy of the ISDA letter is available at http://www.isda.org/speeches/index.html.

Chapter 13

147

because the fees did not create a separate and distinct asset. The T.A.M. distinguished the commitment fees discussed in Revenue Ruling 81-160, noting that the loan commitment fees addressed in that ruling were calculated based on the amount of the undrawn commitment and were paid for the purpose of having money made available when needed. In Federal Home Loan Mortgage Corp. v. Comm’r, 125 T.C. 248 (2005), the court held that nonrefundable fees paid by mortgage sellers to Freddie Mac (there was a .5 percent nonrefundable fee and a 1.5 percent fee that was refunded if the loan was sold) represented an option premium that should be accounted for as a reduction in the purchase price of loans that were actually purchased. The court agreed that there was some uncertainty as to whether a purchase would occur, as evidenced by the fact that the seller was willing to pay a fee to have an option, namely the right not to close (alternatively it could have entered into a fixed commitment to sell with reduced fees). Mortgage sellers had historically failed to close a bit less than 1 percent of the time, suggesting that not too much uncertainty was required to find an option. The court distinguished another case, Chesapeake Fin. Corp. v. Commissioner, 78 T.C. 869 (1982), which had analyzed a loan commitment fee as a fee for a service subject to normal accrual standards on the ground that it involved the origination of a loan, not the purchase of a loan from a prior owner, and also that the option theory was not raised in the case.


“Facility fees” paid on the entire amount of a revolving credit facility (both drawn and undrawn) may also be treated as non-interest FDAP income (and not for example as option premiums) because they do not relate solely to the undrawn amount that the lender is making available at the option of the borrower. See T.A.M. 200514020 (December 29, 2004).

Add at the end of Part E:

Late fees paid on delinquent accounts should qualify as interest that is FDAP but may qualify for the portfolio interest exemption. Other fees that are not tied to the use of money (such as annual fees for maintaining a credit card account) would be FDAP income but not interest.103a

F. Taxation of Debt and Equity Interests in Offshore Issuers—Overview

Replace the word “owed” in the fourth sentence of the first full paragraph on page 797 with the word “owned.”

G. Taxation of Equity Interests in an Offshore Issuer Held by U.S. Persons

2. Anti-Deferral Regimes—Overview

AJCA 2004 repeals the rules applicable to FPHCs and FICs (and excludes foreign corporations from the application of the PHC rules), applicable to taxable years of foreign corporations beginning after December 31, 2004 (and to taxable years of United States shareholders with or within which such taxable years of such foreign corporations end).

For a good general discussion of the CFC regime (and predecessor anti-deferral rules), see Office of Tax Policy, Department of the Treasury, “The Deferral of Income Earned Through U.S. Controlled Foreign Corporations–A Policy Study” (December 2000), available at

103a See Chapter 12, Part C.3.d (in this Supplement).

Chapter 13

148

www.treas.gov/taxpolicy/. See also New York State Bar Association, Tax Section, “Report on the Treasury’s ‘Subpart F’ Study.” The report is available at: www.nysba.org/sections/tax/taxreports/1003report.pdf.

3. Historical Perspective


AJCA 2004 excludes foreign corporations from the application of the PHC rules, applicable to taxable years of foreign corporations beginning after December 31, 2004 (and to taxable years of United States shareholders with or within which such taxable years of such foreign corporations end).

Add the following at the end of the first full paragraph on page 808:

AJCA 2004 repeals the FIC rules, applicable to taxable years of foreign corporations beginning after December 31, 2004 (and to taxable years of United States shareholders with or within which such taxable years of such foreign corporations end). 4. Passive Foreign Investment Companies (PFICs)

The 2008-2009 IRS Business Plan lists “[g]uidance under sections 1296, 1297, and 1298 relating to tiered investments” as a project the IRS expects to complete in the plan year ending June 30, 2009. The 2007-2008 IRS Business Plan had included “[f]inal regulations on gain recognition election and PFIC/CFC overlap rule and other guidance under sections 1296, 1297 and 1298”. The 2006-2007 IRS Business Plan included a substantially similar item, however, the item was not included in the 2005-2006 IRS Business Plan. The 2004-2005 IRS Business Plan had included “[g]uidance on the PFIC provisions.” In 2005, final and temporary regulations were issued addressing the treatment of a corporation that is in the hands of a taxpayer a PFIC for which no QEF election is made and that subsequently fails to meet the definition of a PFIC. See Treasury Regulation §§ 1.1298-3 and 1.1298-3T. This fact pattern is not common for securitization vehicles.


In Notice 2003-34, 2003-1 C.B. 990, the IRS announced that it will scrutinize transactions involving the use of offshore purported insurance companies which invest in hedge funds or typical hedge fund assets in order to take advantage of the insurance company exclusion from passive income under section 1297(b)(2)(B). In describing the suspect transactions, the notice points out that the issuer’s actual insurance activities, if any, were relatively small compared to its investment activities, the issuer’s assets generated investment returns that substantially exceeded the needs of the insurance business, and the issuer generally did not distribute current earnings to stakeholders.

Replace the last sentence of footnote 142 with the following:

Section 1296 was enacted in 1997. The IRS has issued regulations under the section providing procedures for electing mark to market treatment and defining marketable stock. See T.D. 9123, 2004-20 I.R.B. 907.


Chapter 13

149

Temporary regulations have been issued to provide guidance on making an election to purge the PFIC taint. See T.D. 9232, 2006-2 I.R.B. 266.


As the discussion below indicates, making a valid QEF election is subject to numerous technical requirements. In P.L.R. 200327026 (March 24, 2003), the IRS held on one set of facts that a taxpayer’s substantial compliance with those requirements was sufficient to make a valid election where the judicial doctrine of substantial compliance had been satisfied, considering whether the essential purposes of the statute had been fulfilled, whether the taxpayer was attempting to benefit from hindsight by adopting a position inconsistent with its original action or omission, and whether the Service would be prejudiced by the taxpayer’s failure to make the timely elections. In the ruling, QEF elections had been made by a foreign partnership holding PFIC stock rather than by the U.S. partners.

5. Controlled Foreign Corporations (CFCs)


Textron, Inc., discussed in Chapter 5, Part B.2 (in this Supplement), could be read to treat a domestic investment trust (as opposed to its equity holders) as the shareholder in a foreign corporation in determining whether the corporation is a CFC owned by United States shareholders. In that event, the holder of equity in the trust would be required to include in gross income its pro rata share of the CFC’s subpart F income even though the holder owns beneficially less than 10 percent of the stock of the CFC.


In determining how current earnings would be distributed if they were paid out, dividend preferences and limitations on preferred shares and certain currency and other foreign governmental restrictions are taken into account; but other restrictions (including contractual restrictions) on the payment of dividends, such as those provided for in financial covenants contained in a corporation’s debt instruments, are ignored. Also distributions representing a return of capital are not taken into account. See Treasury Regulation § 1.951-1(e)(5), adopted as a final regulation by T.D. 9222 and effective August 25, 2005. 6. Foreign Personal Holding Companies (FPHCs)


AJCA 2004 repeals the FPHC rules, applicable to taxable years of foreign corporations beginning after December 31, 2004 (and to taxable years of United States shareholders with or within which such taxable years of such foreign corporations end).

H. Special Considerations Applicable to Tax-Exempt Organizations


P.L.R.s 200251016, 200251017, and 200251018 (September 23, 2002) confirm this point. An earlier ruling to the same effect is P.L.R. 199952086 (September 30, 1999).

Chapter 13

150

I. Offshore Issuers of Catastrophe Bonds

Catastrophe Bonds are discussed in United States General Accounting Office, “Catastrophe Insurance-–The Role of Risk-Linked Securities and Factors Affecting Their Use” (GAO 02-941) (September 2002). The report is available at htpp://www.gao.gov/new.items/d02941.pdf.


In Notice 2003-34, 2003-1 C.B. 990, the IRS announced that it will scrutinize transactions involving the use of offshore purported insurance companies which invest in hedge funds or typical hedge fund assets in order to take advantage of the insurance company exclusion from passive income under section 1297(b)(2)(B) for PFIC purposes. In describing the suspect transactions, the notice points out that the issuer’s actual insurance activities, if any, were relatively small compared to its investment activities, the issuer’s assets generated investment returns that substantially exceeded the needs of the insurance business, and the issuer generally did not distribute current earnings to stakeholders.


The Service has issued significant recent guidance applying the tax definition of insurance to captive insurance arrangements. See Revenue Ruling 2002-89, 2002-2 C.B. 984; Revenue Ruling 2002-90, 2002-2 C.B. 985; and Revenue Ruling 2002-91, 2002-2 C.B. 991. In Notice 2002-70, 2002-2 C.B. 765, the Service identified as a listed transaction subject to tax-shelter reporting rules arrangements whereby a car dealer or other producer insured customer risks through an independent insurance company, and then, reinsured them through a captive insurance arrangement. The identification of these transactions as a listed transaction was reversed in Notice 2004-65, 2004-41 I.R.B. 599, in part on the ground that further examination revealed fewer abuses than expected.

Revenue Ruling 2005-40, 2005-2 C.B. 4, applies the definition of insurance to a number of fact patterns that involving the shifting of insurance risk. The ruling holds that the requirement of risk distribution is met only if the risks of multiple insured parties are combined. As a result, a contract that shifts risks between two parties (one of which shifts 10 percent of the risk to a third party) is not insurance. A contract that combines the risk of 12 LLCs owned by a single parent is insurance where the LLCs are classified as associations for tax purposes but not where they are disregarded entities.

In Notice 2005-49, 2005-2 C.B. 14, the Service and Treasury asked for comments on the following insurance-related issues: (1) the factors to be taken into account in determining whether a cell captive arrangement constitutes insurance and, if so, the mechanics of any applicable federal tax elections; (2) circumstances under which the qualification of an arrangement between related parties as insurance may be affected by a loan back of amounts paid as “premiums;” (3) the relevance of homogeneity in determining whether risks are adequately distributed for an arrangement to qualify as insurance, and (4) federal income tax issues raised by transactions involving finite risk.

Revenue Ruling 2007-47, 2007-30 I.R.B. 127, held that a contract to shift the cost of remediating land on which the taxpayer conducted a harmful activity was not insurance where the taxpayer knew that remediation would be inevitable and, therefore, lacked the requisite insurance risk. The contract mainly addressed whether actual costs would exceed projected costs or costs would be incurred earlier than anticipated.

Chapter 13

151


Treasury Regulation § 46.4374-1 provides that the requirement to pay the excise tax applies not only to U.S. residents but also to non-residents described in the statute. Interestingly, the regulation is effective only for premiums paid after November 27, 2002, when final regulations were promulgated, even though the preamble to the proposed regulations indicated that the Service believed that nonresidents were required to pay the tax even absent the regulation. See 67 Fed. Reg. 707 (January 7, 2002). Insurance and reinsurance premiums may be exempt from withholding under income tax treaties between the United States and certain other countries (which do not, however, include the countries in which securitization vehicles are typically established). Revenue Procedure 2003-78, 2003-45 I.R.B. 1029, provides instructions for establishing such an exemption. In very general terms, a premium will be exempt from withholding if paid to a foreign insurer or reinsurer that (1) is, after taking account of certain anti-conduit rules, a resident for treaty purposes of a country with which the United States has a treaty containing an excise tax exemption, (2) qualifies for benefits under the relevant treaty, including the limitations on benefits provision and (3) has entered into a specified closing agreement with the IRS (a form of which is attached to the revenue procedure). Premiums will not benefit from the exemption, however, to the extent that the risks covered by such premiums are reinsured with a person not entitled to the benefits of the relevant treaty (or another treaty that provides a similar exemption). Revenue Ruling 2008-15, 2008-12 I.R.B. 633, applies the excise tax to reinsurance arrangements involving a foreign insurer eligible for tax treaty benefits and a foreign reinsurer that is not eligible. In connection with this ruling, the IRS in Announcement 2008-18, 2008-12 I.R.B. 667, announced a voluntary program to improve compliance with the insurance excise tax rules.

152

Chapter 14 Legending and Information Reporting B. REMIC Regular Interests and Pay-Through Bonds

3. Ongoing Reporting

Add the following after the phrase “February 28” in footnote 17:

(March 31, if filed electronically)

Add the following after the phrase “February 28” in the text accompanying footnote 29 (and the last sentence and citation in footnote 29 is deleted):


C. Pass-Through Certificates Issued by Grantor Trusts

Add a new heading at the beginning of Part C:

1. Overview


Revenue Ruling 92-105 was distinguished in Revenue Ruling 2004-86, 2004-33 I.R.B. 191, discussed in Part D.2.c, below (in this Supplement). See Chapter 4, footnote 50 (as amended in this Supplement).

Replace Part C from the top of page 847 through the end of the Part on page 850 with the following:

After a long administrative process, final regulations were issued at the beginning of 2006 that overhaul the information reporting rules for pass-through certificates issued by a grantor trust qualifying as a widely held fixed investment trust (WHFIT). The new rules came into effect on January 1, 2007 (meaning they first applied to report activity for the 2007 calendar year).47 The term 47 The new rules for WHFITs are found in Treasury Regulation § 1.671-5. They were adopted on

January 23, 2006 by T.D. 9241, 2006-7 I.R.B. 427, which includes a preamble explaining the regulations. Unless otherwise noted, references below to the preamble to the final regulations are to this preamble. The January 1, 2007 application date is in Treasury Regulation § 1.671-5(m). There is no general grandfather rule for pre-existing WHFITs, although certain types of reporting will not be required for “qualified NMWHFITs” based on their already being in existence and funded by certain dates. See Part C.2.e.(ii), below. The regulations were first proposed in 1998 and then withdrawn and reproposed in 2002. Since January 2006, the final regulations have been further amended and clarified. See T.D. 9279, 2006-36 I.R.B. 355 (July 28, 2006), and T.D. 9308, 2007-8 I.R.B. 523 (December 26, 2006). T.D. 9308 indicated that the IRS would not assert penalties for failing to comply with the WHFIT rules in 2007 in cases where the trustee or middleman was unable to change its information reporting systems to comply with the WHFIT reporting rules. Notice 2008-77, 2008-40 I.R.B. 814 extends this penalty relief to 2008.

Chapter 14

153

WHFIT is defined broadly enough to cover virtually all trusts organized in the United States that issue pass-through certificates. Prior law rules will continue to apply to grantor trusts that are not WHFITs.

The WHFIT regulations were issued because the pre-2007 reporting system for grantor trusts did not provide adequate information to enable pass-through trust investors to calculate income accurately under grantor trust look-through principles, particularly where certificates were held through middlemen. For example, items of income and expense with potentially different tax consequences were netted, and often the only information provided with respect to principal payments and sales was the amount of principal distributions to certificate holders. The new regulations will require information at a level of detail that is closer to partnership reporting.

The discussion below will consider first in Part C.2 the rules for WHFITs and then in Part C.3 the rules for periods prior to January 1, 2007 and for non-WHFIT grantor trusts thereafter. The new rules for WHFITs are quite detailed and complex, and the discussion in the next section is only a summary.

2. Reporting by WHFITs

a. Terminology and Overview. Despite the name, a WHFIT need not be widely held. Rather, a WHFIT is any domestic48 fixed investment trust that is taxable as a grantor trust if any

48 Treasury Regulation § 1.671-5(b)(22)(i) (limitation to domestic trusts). As noted in Part H.4,

below, the tax definition of a foreign trust includes certain trusts that are organized under U.S. law with domestic trustees. According to the preamble to the 2002 reproposed regulations, the definition of WHFIT was limited to domestic trusts because foreign trusts are subject to separate reporting requirements under section 6048 and the government was studying how those rules ought to be adapted for use with foreign fixed investment trusts. However, the current reporting requirements of section 6048 cannot be complied with (a matter of impossibility, not convenience) in the case of trusts with widely held transferable interests. The preamble to the January 2006 final regulations acknowledges that commentators have indicated that information necessary to comply with section 6048 reporting cannot be obtained and suggested that foreign fixed investment trusts should be allowed to report under the WHFIT rules in lieu of the section 6048 rules. This preamble indicates that the IRS intends “to provide guidance in the area of foreign trust reporting and will consider whether any of the suggested approaches for WHFITs are more appropriate in this context.” Given how long it took to issue final regulations governing domestic WHFITs, it may be that the delay reflects a limitation on resources available to push reporting regulations through the door rather than a real policy debate. It seem obvious in policy terms that applying the reporting scheme for WHFITs to foreign trusts is the right approach, at least where there is a financial institution or other responsible person other than the grantor who has reporting obligations. The WHFIT reporting rules are designed with pass-through certificate trusts in mind, and the foreign trust reporting rules are not. The NYSBA Reforms Report, in a comment on the 2002 reproposed regulations, recommends that the WHFIT reporting rules be applied (in lieu of section 6048) to all foreign fixed investment trusts having at least one trustee that is a domestic bank or U.S. government-owned or sponsored agency, and also to those foreign trusts that elect to be subject to the rules and designate such a domestic person as a person responsible for complying with the WHFIT reporting rules. Given the impossibility of complying with the section 6048 rules and the long delay in resolving this issue, it may be hoped that the IRS will not seek to impose penalties with respect to any trust issuing transferable pass-through certificates in a commercial setting for a failure to comply with section 6048 absent some evidence that the trust was established to facilitate tax evasion by hiding assets abroad.

Chapter 14

154

interest in the trust is held by a middleman (including virtually any type of custodian or nominee).49

Investors in trusts that hold mortgages may need special information to compute income produced by prepayments. To accommodate these needs, the final regulations contain modified rules for WHFITs that are widely held mortgage trusts (WHMTs). A WHFIT is a WHMT if its assets consist of mortgages, interests in REMICs or other WHMTs, amounts received on such assets, and reasonably required reserve funds.50 A WHFIT that is not a WHMT is a non-mortgage widely held fixed investment trust (NMWHFIT).51 One can debate how these terms are said out loud, at least by speakers of standard English.

The main goal of the regulations is to require more detailed reporting of all relevant tax items to trust interest holders.52 Perhaps the most difficult items to report are those relating to sales of assets by a trust and other dispositions, including principal payments. Principal payments come in different flavors and may have different consequences depending on whether they are scheduled payments, pro-rata prepayments or non-pro rata prepayments. The tax treatment of discount and premium on debt obligations and the treatment of principal payments are discussed in Chapter 8. With a view to balancing the burdens of reporting with the need for information, the regulations provide simplified reporting as to dispositions and certain other matters for WHFITs that meet a de minimis test (relating to dispositions), for partially grandfathered NMWHFITs (referred to as qualified NMWHFITs) and for certain other NMWHFITs and WHMTs. These special rules will be noted as relevant below.

Under the final regulations, a trustee for a WHFIT is no longer required to file a basic trust tax return on Form 1041 (with an attached statement). Instead, the somewhat elaborate reporting scheme outlined below applies. It involves reporting by the trust to the IRS and to trust interest holders (TIHs),53 and reporting by middlemen, again to the IRS and to TIHs. Also, in recognition of the fact that information reporting is needed not just to prevent the omission of income from a return but also to help taxpayers to calculate income, the regulations distinguish between information reported to the IRS on Form 1099 and more complete information provided to taxpayers or intermediaries to assist in tax calculations.

49 Treasury Regulation §§ 1.671-5(b)(10) (middleman) and (b)(22) (WHFIT). 50 Treasury Regulation § 1.671-5(b)(23). A WHMT does not fail to meet this definition merely

because it holds, during a brief initial funding period, both cash and short-term contracts for the purchase of mortgages, interests in REMICs, and interests in other WHMTs. The definition of a WHMT in the proposed regulations had provided that “substantially all” of the assets (by value) had to consist of these enumerated assets.

51 Treasury Regulation § 1.671-5(b)(12). 52 The term “item” as used in the regulations is defined broadly. It includes any item of income,

expense, or credit as well as any trust event (for example, the sale of an asset) or any characteristic or attribute of the trust that affects the income, deductions, and credits reported by a beneficial owner in any taxable year that the beneficial owner holds an interest in the trust. An item may refer to an individual item or to groups of items depending on whether they are to be reported individually or on an aggregate basis. See Treasury Regulation § 1.671-5(b)(9).

53 A TIH is any person who holds a direct or indirect interest, including a beneficial interest, in a WHFIT. Treasury Regulation § 1.671-5(b)(20). A TIH who holds a beneficial interest is a beneficial owner. Treasury Regulation § 1.671-5(b)(3).

Chapter 14

155

Part C.2.b, below, describes who reports to whom under the new reporting scheme. Part C.2.c discusses the timing and method of reporting, and Part C.2.d discusses what information must be provided, in each case under the general rules. Part C.2.e discusses exceptions and shortcuts allowed to certain categories of trusts. Finally, Part C.2.f discusses a proposal to create a directory of WHMT trustees and NMWHFITs.

b. Who Reports to Whom. Reporting is required by the following parties:

• The trustee for a WHFIT must file Form 1099s annually with the Service reporting tax information with respect to a TIH, but only where trust certificates are held directly by U.S. individuals, or other U.S. persons that are not exempt recipients.54

• Where payments are made by a trust through one or more middlemen, the last person in the chain (excluding any clearing organization)54a making payment to a person who is not an exempt recipient is responsible for reporting such payment to the Service on Form 1099.54b

• Any person (trustee or middleman) filing a Form 1099 with respect to a TIH must also provide the TIH with an annual statement consistent with the 1099.54c

• Middlemen, and exempt recipients or non-calendar-year TIHs holding certificates directly (not through a middleman), may request tax information for any calendar year from the trustee for the WHFIT.54d

• Exempt recipients or non-calendar-year TIHs holding certificates through a middleman may request tax information for any calendar year from that middleman.54e

• Payments a WHFIT makes to a foreign person are subject to the normal withholding and reporting rules for such payments.54f

c. Timing and Method of Reporting—General. Form 1099s generally must be filed by a trustee or middleman on or before February 28 (March 31, if filed electronically) of the year

54 Treasury Regulation § 1.671-5(d)(1). The definition of “exempt recipient” is in Treasury

Regulation § 1.671-5(b)(7). It tracks the normal definition used under section 6049 (see footnote 20, above) but also includes middlemen, REMICs, other WHFITs, and certain trusts or estates for which the trustee or middleman of the WHFIT is required to file an income tax return.

54a Treasury Regulation § 1.671-5(h)(4). 54b Treasury Regulation § 1.671-5(d)(1)(B). 54c Treasury Regulation § 1.671-5(e). 54d Treasury Regulation § 1.671-5(c)(1). The definition of “requesting person” is in -5(b)(16). 54e See Treasury Regulation § 1.671-5(h). 54f Treasury Regulation § 1.671-5(d)(1)(iii) provides that payments a WHFIT makes to a foreign

person are not required to be reported to the Service on Form 1099s. Instead, such payments must be reported under the rules of sections 1441 through 1464. Read literally, this carve-out applies only to Form 1099 reporting and not to the other reporting requirements of the final regulations. It would not make sense, however, to require additional reporting for foreign investors.

Chapter 14

156

following the year for which they are filed.54g The time for a middleman to file Form 1099 is the same as for the trustee.54h

The corresponding statement the trustee or middleman furnishes to the TIH must be provided on or before March 15 of the year following the year for which the statement is furnished.54i The person sending the statement must retain in its records, for a period of five years from the date on which the statement is due, not only a copy of the statement, but also such additional data as may be required to establish its correctness.54j

A trust must provide tax information to requesting exempt recipients, middlemen, or non-calendar-year TIHs on or before the later of (1) the 30th day after the close of the calendar year for which the information was requested or (2) the day that is 14 days after receipt of the request.54k However, if the WHFIT holds an interest in another WHFIT, a regular interest in a REMIC, or both, the two deadlines are extended to the 44th day after the close of the calendar year or 28 days after receipt of the request.54l The information statement may be provided by any of several methods.54m A request for information may be made, beginning with 2007 and ending five years after the trust terminates, for any calendar year of the trust’s existence.54n The final regulations do not require WHFITs to file Form 8811s and, accordingly, contact information for a particular trustee would not be included in IRS Publication 938. Instead, the trustee is required to identify the person to call to request the relevant tax information.54o However, as described in Part C.2.f, below, the Service has proposed to expand the scope of Publication 938 to include WHFIT trustees and NWHFITs. A five-year record retention requirement applies to WHFIT trustees providing information to requesting persons.54p

The trustee must report information on a calendar year basis. The trustee may choose a calendar month, or a quarter, half or full calendar year as the calculation period, but must use the same calculation period throughout the trust’s existence.54q

54g Treasury Regulation § 1.671-5(d)(3). 54h Treasury Regulation § 1.671-5(d)(3). 54i Treasury Regulation § 1.671-5(e)(3). 54j Treasury Regulation § 1.671-5(e)(4). 54k Treasury Regulation § 1.671-5(c)(4)(i)(A). 54l Treasury Regulation § 1.671-5(c)(4)(i)(B). 54m The trustee may provide the information by first class mail, by electronic mail (provided the

requesting person requests statements by electronic mail and provides an electronic mail address), or by posting on an internet site (provided the internet address is published, either in a publication generally read by and available to requesting persons, in the trust’s prospectus, or on the trustee’s internet site). See Treasury Regulation § 1.671-5(c)(4)(ii).

54n Treasury Regulation § 1.671-5(c)(5)(iii). 54o The contact person may be identified either in a publication generally read by and available to

requesting persons, in the trust’s prospectus, or on the trustee’s internet site. See Treasury Regulation § 1.671-5(c)(3).

54p Treasury Regulation § 1.671-5(c)(6). 54q Treasury Regulation § 1.671-5(c)(1)(ii).

Chapter 14

157

Trust information generally must be calculated and reported using the cash method of accounting, except where particular trust items are required to be calculated using a different method (for example, OID and interest on REMIC regular interests must be accrued by all taxpayers).54r However, the trustee must calculate and report trust information using the accrual method of accounting if the WHFIT is marketed predominantly to taxpayers on the accrual method and using that method would materially affect the timing of recognition of income from the trust’s assets.54s Pending further guidance there is no need to report mortgage modifications if any shortfall is made up under a guarantee arrangement.54ss

Similar rules apply where a middleman provides tax information to requesting exempt recipients or non-calendar-year TIHs. A middleman must provide the same tax information it receives from the trustee. The information must be provided on or before the later of the 44th day after the close of the calendar year for which the request is made, and the day that is 28 days after the receipt of the request. In the event the WHFIT holds an interest in another WHFIT or an interest in a REMIC, these dates are extended to the 58th day and the 42nd day, respectively.54t A middleman may generally use the same methods of providing the information as a trustee.54u

d. What is Reported—General. This section describes the information that generally must be provided on Form 1099 and the more extensive information that must be included in a statement to a TIH. Special rules for certain categories of reporting persons are discussed in the next section (Part C.2.e).

(i) Form 1099. A Form 1099 for a calendar year must include information identifying the filer and the TIH, and the following amounts for the trust attributable to the TIH for the year:

• items of gross income,

• non pro-rata partial principal payments,

• sales proceeds (including principal payments other than a scheduled final principal payment, made in payment of all or a pro rata portion of a debt instrument),

• amounts paid to the TIH in redemption of certificates, or for the sale of certificates on a secondary market established for the WHFIT (less cash held for distribution with respect to the redeemed or sold interest), and

• any other information required by the form.54v

(ii) Statement to TIH. In general, a trustee or middleman who is required to file a Form 1099 with respect to a TIH must provide to the TIH an annual information statement that identifies the WHFIT and the person furnishing the statement, and lists those amounts described

54r Treasury Regulation § 1.671-5(c)(1)(iii)(A). 54s Treasury Regulation § 1.671-5(c)(1)(iii)(B). 54ss Notice 2008-77, 2008-40 I.R.B. 814. 54t Treasury Regulation § 1.671-5(h)(2). 54u Treasury Regulation § 1.671-5(h)(3). 54v Treasury Regulation § 1.671-5(d)(2)(ii).

Chapter 14

158

below that are attributable to the TIH for the year. The information statement must separately identify any item that if taken into account separately would change the TIH’s income tax liability.54w The items that must be reported are:54x

• each item of income (including items required to be reported on Form 1099s), expense and credit that is attributable to the TIH for the year,54y

• each non pro-rata partial principal payment attributable to the TIH,

• with respect to each sale or disposition of a trust asset:54z the date of the sale or disposition, information regarding the trust sale proceeds attributable to the TIH, and information that would enable the TIH to allocate with reasonable accuracy a portion of its basis in its interest to the sale or disposition,

• information regarding gross proceeds from redemptions and sales of certificates required to be reported on Form 1099,

• information regarding any amortizable bond premium and market discount accrued during the year,54aa

54w Treasury Regulation § 1.671-5(e)(1). Under this rule, expenses allocable to the TIH that qualify as

miscellaneous itemized deductions would be separately reported. According to the preamble to the 2002 reproposed regulations, other examples of such information would include (1) items of tax preference subject to the alternative minimum tax imposed by section 55, (2) investment interest and investment income and expense necessary to compute limitations under section 163(d), (3) income from oil and gas subject to depletion under sections 613 and 613A, (4) most depreciation and depletion expenses, and (5) intangible drilling and development costs referred to in section 263(c). The preamble to the 2002 reproposed regulations states that this rule is not intended to require asset-by-asset reporting. 2002-2 C.B. 190, 192.

54x The required information is listed in Treasury Regulation § 1.671-5(e)(2). 54y A WHFIT that is also a WHMT with a start-up date prior to August 13, 1998, is exempt from the

general requirement to provide OID information. Treasury Regulation § 1.671-5(c)(2)(ii)(A). 54z The exchange of trust assets for other assets of equivalent value pursuant to a tax free corporate

reorganization is not required to be reported as a sale or disposition. Treasury Regulation § 1.671-5(c)(2)(iv)(H).

54aa Treasury Regulation § 1.671-5(e)(2)(vii), which cross-references -5(c)(2)(vi) and (vii). More specifically, the statement must include information that enables a beneficial owner to determine, in any manner reasonably consistent with section 171 (dealing with bond premium) and section 1276(a)(3) (dealing with market discount and partial principal payments), the beneficial owner’s portion of amortizable bond premium and the amount of market discount that has accrued during the year. The preamble to the 2002 reproposed regulations provided that pending the issuance of guidance under section 1272(a)(6)(C)(iii) (PAC method), a trustee might, but was not required to, provide market discount and OID information calculated consistent with the application of section 1272(a)(6)(C)(iii). 2002-2 C.B. 190, 194. See also the discussion below of the WHMT safe harbor rules in Treasury Regulation § 1.671-5(g)(1), which contemplate that the PAC method will be applied using the prepayment assumption used in pricing the original issue of pass-through certificates. The preamble to the 2002 reproposed regulations also noted that pending the issuance of regulations under section 1276(b)(3), market discount should be accrued and reported in accordance with the 1986 Conference Report. See Chapter 8, Part E.2, text accompanying footnote 109. The preamble to the January 2006 final regulations summarizes the discussion in

Chapter 14

159

• any other information necessary for the TIH to report with reasonable accuracy its items of income, deduction, or credit under the grantor trust rules. For items that are not required to be reported on a Form 1099, the information statement may report them on a per trust interest basis if that is how the trustee reported or calculated those items.54bb

e. What is Reported—Special Rules. The general reporting requirements are partially relaxed for trusts meeting certain de minimis tests or in certain special circumstances. The discussion below considers:

• the general WHFIT de minimis exception,

• the qualified NMWHFIT exception (a grandfather rule),

• the special de minimis exception for WHMTs, and

• the NMWHFIT final tax year exception.

(i) General de minimis exception. The general WHFIT de minimis test is satisfied for a trust if trust sales proceeds for the calendar year (generally including principal payments) are not more than 5 percent54cc of the aggregate fair market value of all assets held by the trust as of January 1 of that year (or if it was not in existence on January 1, the date substantially all of the assets were deposited with the trustee).54dd A NMWHFIT that satisfies this test is exempt from reporting

the preamble to the 2002 reproposed regulations. 2006-7 I.R.B. 428-34. This preamble also clarifies that in the Service’s view the 1986 Conference Report does not authorize a trustee to report market discount using a single composite fraction if the trust does not qualify for and employ WHMT safe harbor reporting. The WHMT safe harbor rule in Treasury Regulation § 1.671-5(g)(1)(v), discussed below, provides for market discount to be accrued in proportion to OID accruals, where relevant, and otherwise based on the ratio of current payments of stated interest to all remaining stated interest.

54bb Treasury Regulation § 1.671-5(e)(2)(viii). The statement must also inform the TIH that the items reported must be taken into account in calculating the taxable income and credits of the TIH. If the statement reports that an amount of qualified dividend income is attributable to the TIH, the statement must also inform the TIH that it must satisfy the requirements of section 1(h)(11)(B)(iii) in order to treat the dividends as qualified dividends. Treasury Regulation § 1.671-5(e)(2)(ix).

54cc For NMWHFITs this 5 percent limit is relaxed in two respects. First, sales proceeds deriving from certain nonvolitional dispositions of trust assets may be excluded for purposes of applying the 5 percent limit, provided the trustee reports these as otherwise required, and does so consistently throughout the life of the trust. Treasury Regulation §§ 1.671-5(c)(2)(iv)(D)(4) and 1.671-5(c)(2)(iv)(A). Second, where a trustee sells trust assets on a strictly pro rata basis to redeem interests held by a TIH that is deemed to own the assets sold, and the cash is immediately distributed to the redeeming TIH, the redemption must be reported under section 1.671-5(c)(2)(v), but the cash received by the trustee does not constitute “trust sale proceeds” under section 1.671-5(b)(21) and thus does not count toward the 5 percent limit. In addition, a trust will not fail to meet either the general de minimis test or the special WHMT de minimis test (described below) solely because of the exercise of a clean-up call (the redemption of certificates in termination of the trust when the administrative costs outweigh the benefits of going on). Treasury Regulation § 1.671-5(c)(2)(iv)(D)(3).

54dd Treasury Regulation § 1.671-5(c)(2)(iv)(D)(1). A trustee may also elect to use a “measuring date” to test whether the trust qualifies under the general de minimis test. The measuring date is the date of the last deposit of assets into the WHFIT (not including any deposit made pursuant to a

Chapter 14

160

requirements relating to market discount and bond premium.54ee Further, such a NMWHFIT need only report information sufficient to determine the amount of trust sales proceeds distributed (rather than attributable) to a beneficial owner during the calendar year.54ff Information relating to redemptions and sales generally must be reported under as described above.54gg

A WHMT that fails the special WHMT de minimis test (discussed below) but satisfies this general WHFIT de minimis test must report, with respect to dispositions of trust assets, information sufficient to determine the amount of trust sales proceeds attributable (rather than distributed) to a beneficial owner during the calendar year.54hh Such a WHMT must report bond premium, market discount, and redemptions and sales of trust interests under the general rules.

(ii) Qualified NMWHFIT exception. The qualified NMWHFIT exception is a grandfather rule that applies to all NMWHFITs if the NMWHFIT meets any of the following requirements: (1) the NMWHFIT had a start-up date (the date when substantially all of the assets have been deposited with the trustee) before February 23, 2006; (2) a registration statement for the NMWHFIT became effective under the Securities Act of 1933 and trust interests were offered for sale to the public before February 23, 2006; or (3) a registration statement for the NMWHFIT became effective under the Securities Act of 1933 and trust interests were offered for sale to the public on or after February 23 and before July 31, 2006, and the NMWHFIT was fully funded before October 1, 2006.54ii A NMWHFIT is “fully funded” even if it later receives deposits under a distribution reinvestment program, provided the reinvestment program is consistent with Treasury Regulation § 301.7701-4(c).54jj A sunset provision in prior temporary regulations that would have eliminated grandfathered reporting for reporting years beginning on or after January 1, 2011 has been removed; qualified NMWHFITs are now grandfathered in perpetuity.

In general, a qualified NMWHFIT is treated like a NMWHFIT that satisfies the general de minimis test. However, where substantially all of the income of a qualified NMWHFIT consists of dividends (or where substantially all of the NMWHFIT’s assets produce income treated as interest, provided the assets trade on a recognized exchange or market without a price component attributable to accrued interest), it is also exempt from the general reporting requirements relating to redemptions and sales of trust interests. Instead, the trustee must report, for each date on which proceeds to be paid in redemption of a trust interest are determined, information enabling a TIH to determine redemption proceeds per trust interest.54kk

dividend reinvestment program), not to exceed 90 days after the date the WHFIT’s registration statement becomes effective under the Securities Act of 1933.

54ee Treasury Regulation §§ 1.671-5(c)(2)(vi) and (vii). 54ff Treasury Regulation § 1.671-5(c)(2)(iv)(B). 54gg Treasury Regulation § 1.671-5(c)(2)(v). 54hh Treasury Regulation § 1.671-5(c)(2)(iv)(B). 54ii Treasury Regulation § 1.671-5(c)(2)(iv)(E). 54jj Treasury Regulation § 1.671-5(c)(2)(iv)(E)(3). 54kk Treasury Regulation § 1.671-5(c)(2)(v)(C). Note that where substantially all of a NMWHFIT’s

income consists of dividends, and the trustee is required by the governing documents to distribute all cash (less reasonably required reserve funds) at least monthly, the trustee must report information relating to sales and redemptions of trust interests as described in the text, even if the

Chapter 14

161

(iii) Special de minimis exception for WHMTs. A special WHMT de minimis test applies to WHMTs whose assets are limited to mortgages with “uniform characteristics,” reasonably required reserves and amounts received on mortgages or reserve funds and held for distribution to TIHs. The test is satisfied for a calendar year if trust sales proceeds (but this time excluding principal payments) are not more than 5 percent of the aggregate outstanding principal balance of the WHMT (including amounts received and held for distribution and the amount of the reserve fund that is not undistributed income) as of the later of January 1 or the date substantially all the assets were deposited with the trustee.54ll A WHMT that satisfies either this special de minimis test or the general WHFIT de minimis test described above is exempt from the detailed general reporting requirements relating to trust sale proceeds. Instead, it must report information sufficient to enable the amount of trust sales proceeds attributable (as opposed to distributed) to a beneficial owner to be computed.54mm Information relating to bond premium, market discount, and redemptions and sales must be reported under the general rules.

(iv) NMWHFIT final tax year exception. All NMWHFITs are treated as if they qualified for the general de minimis test during their final calendar year (provided beneficial owners exchange their interests for cash or are treated as having done so upon termination of the trust).54nn

f. Simplified Reporting. Certain NMWHFITs and WHMTs are eligible for safe harbor rules that permit simplified reporting of certain categories of tax information.

(i) Safe harbor for certain NMWHFITs. The final regulations allow a trustee for certain NMWHFITs to use a safe harbor to report items relating to income and expenses, non pro-rata partial principal payments, sales of assets, redemptions and sales of certificates, OID and market discount.54oo To qualify for the safe harbor, the NMWHFIT must have only one class of certificates and derive substantially all of its income from dividends and interest.54pp In addition,

NMWHFIT does not satisfy the qualified NMWHFIT exception. See Treasury Regulation § 1.671-5(c)(2)(v)(C)(1).

54ll Treasury Regulation §§ 1.671-5(c)(2)(iv)(D)(2). According to the December 2006 preamble, the special WHMT de minimis test was added in acknowledgement of the difficulty of annually determining the fair market value of the mortgages held by a WHMT. The Service has acknowledged that similar treatment may be appropriate for non-WHMTs holding difficult-to-value assets, and has asked for additional comments on this issue. The regulation provides that application of the special de minimis test may be expanded by revenue ruling or other published guidance.

54mm Treasury Regulation § 1.671-5(c)(2)(iv)(C). If the trustee reports under safe harbor rules, then the statements provided to TIHs must so indicate and must be computed in a manner consistent with the relevant safe harbor. Treasury Regulation §§ 1.671-5(f)(2)(i) and (g)(2)(i).

54nn Treasury Regulation §§ 1.671-5(c)(2)(iv)(F) and 1.671-5(c)(2)(iv)(B). This rule was added in the December 2006 regulations in response to comments to the effect that for many NMWHFITs, almost all of the trustee’s assets sales to effect redemptions occur during the last three months of the NMWHFIT’s existence, and that non-redeeming TIHs generally cash out of their investment in the same calendar year.

54oo Treasury Regulation § 1.671-5(f)(1). 54pp Treasury Regulation § 1.671-5(f)(1)(i)(A). Treasury Regulation § 1.671-5(f)(1)(i) provides that

trust sales proceeds are not relevant in determining whether a NMWHFIT is eligible to report under the NMWHFIT safe harbor in Treasury Regulation § 1.671-5(f). Accordingly, a

Chapter 14

162

the trustee generally must calculate all items under the safe harbor rules and must do so consistently throughout the life of the NMWHFIT.54qq The safe harbor methods must be used in determining tax information included in Form 1099s and statements provided to certificate holders.54rr The safe harbor reporting rules are summarized below:

• The trustee must report items of income and expense for a calendar year using “factors” that express each item as a percentage of the total distributions made during the year (or deemed made out of year-end cash balances or cash that is reinvested). Distributions in redemption of certificates, as well as distributed trust sales proceeds and non pro-rata partial principal payments are disregarded. The items allocable to a particular certificate holder can then be determined by multiplying the factor by the distributions or deemed distributions made to that holder.54ss

• The trustee must provide a list of dates on which non pro-rata partial principal payments were distributed by the trust, and the amount distributed, per trust interest.54tt

• For NMWHFITs not meeting either the general WHFIT de minimis test or the qualified NMWHFIT exception (both discussed above), the trustee must provide a list of the dates on which assets were sold or disposed of during the calendar year. The trustee must include for each sale date the sales proceeds received per trust interest, the sales proceeds distributed to TIHs per trust interest (and the date of such distribution) and the percentage of all assets of the trust represented by the assets sold or disposed of, on that date. That percentage must be determined based on the fair market value of the assets on the date of the sale or disposition, unless the trust terminates within 24 months of the start-up date, in which case values as of the start-up date must be used.54uu

• For NMWHFITs meeting either the general WHFIT de minimis test or the qualified NMWHFIT exception (see above), the trustee must provide the list of dates described in the last bullet point, but need only include for each date identified the total amount of trust sale proceeds per trust interest for all sales or dispositions of assets on that date.54vv

NMWHFIT may be eligible to report under the NMWHFIT safe harbor even if it has significant proceeds from the sale or disposition of trust assets.

54qq Treasury Regulation § 1.671-5(f)(1)(i)(B)(i). Trusts with start-up dates before January 1, 2007 must begin reporting under the safe harbor as of that date. The start-up date is the date when substantially all of the assets have been deposited with the trustee. Treasury Regulation § 1.671-5(b)(19).

54rr Guidance for determining the information required under the safe harbor is found in Treasury Regulation § 1.671-5(f)(2). If the information reported under the safe harbor cannot be used to determine with reasonable accuracy the income and expense attributable to a TIH, then upon request of the TIH, the trustee must provide additional information needed to meet the reasonable accuracy standard. Treasury Regulation § 1.671-5(f)(1)(x).

54ss Treasury Regulation § 1.671-5(f)(1)(ii). If the total actual and deemed distributions is zero or a negative number, the trustee may not report income and expense under the safe harbor but may report all other items under the safe harbor. Treasury Regulation § 1.671-5(f)(1)(ii)(A).

54tt Treasury Regulation § 1.671-5(f)(1)(iii). 54uu Treasury Regulation § 1.671-5(f)(1)(iv)(A). 54vv Treasury Regulation § 1.671-5(f)(1)(iv)(B).

Chapter 14

163

• For redemptions, the trustee must provide a list of dates on which a redemption price of a certificate was determined, and for each date, the amount of the redemption asset proceeds per trust interest, determined on that date. Alternatively, the trustee may provide upon the request of each TIH whose certificates were redeemed, the date of the redemption and the amount of the redemption asset proceeds per interest, determined on that date.54ww

• For sales of certificates on the secondary market, the trustee must provide, for each day of the calendar year, the amount of cash held for distribution as of that date. If the trustee is able to ascertain the dates of all actual sales of interests on the secondary market, the trustee must only report the amount of cash held for distribution as of those dates.54xx

• OID information must be provided by giving for each calculation period, the average aggregate daily accrual of OID per $1,000 of original principal amount.54yy

For NMWHFITs not meeting either the general WHFIT de minimis test or the qualified NMWHFIT exception, market discount information must be provided by giving a list of dates on which sales of interests occurred, and for each date, the percentage of all assets of the trust represented by the assets sold or disposed of, on that date. For trusts meeting either the general WHFIT de minimis test or the qualified NMWHFIT exception, no market discount information need be provided.54zz

(ii) Safe harbor for certain WHMTs. A WHMT qualifies for a safe harbor if (1) its assets consist exclusively of mortgages with uniform characteristics, reasonably required reserves, and amounts received on such mortgages and reserves and held for distribution to TIHs, (2) the principal amount of its assets matches the aggregate face amount of the interests it issues, (3) it issues only certificates representing the right to pro rata shares of both income and principal payments, and (4) it distributes income and principal every month. As with the safe harbor for

54ww Treasury Regulation § 1.671-5(f)(1)(v). For either alternative, if the NMWHFIT satisfies the test

of Treasury Regulation § 1.671-5(c)(2)(v)(C) (see footnote 54kk above and accompanying text), the trustee must provide, for each date on which the amount of redemption proceeds to be paid for the redemption of a trust interest is determined, information that will enable the requesting persons to determine the redemption proceeds per trust interest on that date. Redemption asset proceeds means the total amount paid in redemption of the TIH’s trust interest, less the cash held for distribution with respect to the redeemed interests. Treasury Regulation § 1.671-5(b)(14) and (b)(15).

54xx Treasury Regulation § 1.671-5(f)(1)(vi). If the NMWHFIT satisfies the test of Treasury Regulation § 1.671-5(c)(2)(v)(C) (relating to “equity trusts” and certain others, see footnote 54kk, above), this information need not be reported under the safe harbor.

54yy Treasury Regulation § 1.671-5(f)(1)(vii). 54zz Treasury Regulation § 1.671-5(f)(1)(viii). To enable a TIH to determine the amount of market

discount that it is to allocate to a particular sale or disposition of debt instruments by the NMWHFIT, the regulations for NMWHFITs that hold debt instruments with OID include a requirement that trustees provide the aggregate adjusted issue price of the debt instruments held by the NMWHFIT per trust interest as of the start-up date as well as of January 1 of each subsequent year of the NMWHFIT. Treasury Regulation § 1.671-5(f)(1)(viii)(A).

Chapter 14

164

NMWHFITs, the WHMT safe harbor requires the trustee to use the safe harbor rules consistently for all items and throughout the life of the WHMT (starting January 1, 2007).54aaa

For a WHMT that qualifies for the safe harbor, expense and income factors are computed on a monthly basis (not for the calendar year) and are allocated among certificates based on their principal amounts, not distributions.54bbb The rules for periods after issuance of regulations under section 1272(a)(6)(C)(iii) (PAC method) are reserved.54ccc Prior to the issuance of those regulations, however, the trustee may report OID using a daily accrual amount per $1,000 of original principal. In calculating the daily accrual, the trustee must use the prepayment assumption used in pricing the original issue of pass-through certificates.54ddd WHMTs qualifying for the safe harbor are permitted to combine, for reporting purposes, proceeds from the sale or disposition of mortgages with full and non pro-rata partial principal payments, in effect reporting as if the trust held only a single mortgage, and had received a non pro-rata partial principal payment on that mortgage each time a mortgage in the pool is disposed of or partially prepaid.54eee

Until the issuance of regulations under section 1276, relating to accruals of market discount on debt instruments providing for partial principal payments, accruals of market discount must be made (1) in proportion to accruals of OID in the case of mortgages issued with OID, and otherwise (2) in proportion to the ratio of current interest payments to the amount of all stated interest remaining to be paid (computed using the original prepayment speed).54fff If and when regulations under section 1276 are issued, they will, of course, control. The rules for calculating premium are reserved.54ggg The final regulations provide guidance on how to calculate items for individual certificate holders based on the reported factors.54hhh

54aaa Treasury Regulation §§ 1.671-5(g)(1)(ii)(C) through (F). The requirement that all certificates be

entitled to a pro rata share of interest and principal would seem to preclude senior and junior certificates and, presumably, also interest strips. Treasury Regulation 1.671-5(g)(i)(ii)(B). It is not clear whether an interest strip represented by excess servicing would pose a problem.

54bbb Treasury Regulation § 1.671-5(g)(1)(iii). 54ccc Treasury Regulation § 1.671-5(g)(1)(iv)(B). 54ddd Treasury Regulation § 1.671-5(g)(1)(iv)(A). For WHMTs with a start-up date prior to January 24,

2006, if a trustee does not know the prepayment assumption used in pricing the original issue of trust interests, and has made a good faith effort to obtain this information, the trustee may use any reasonable prepayment assumption, provided the assumption is used consistently. Treasury Regulation § 1.671-5(g)(1)(iv)(A)(2). Further, a WHMT with a start-up date prior to August 13, 1998 is exempt from the general requirement to provide OID information, whether or not it qualifies for the WHMT safe harbor. Treasury Regulation § 1.671-5(c)(2)(ii)(A).

54eee The January 2006 preamble explains that while commentators had indicated that this treatment was consistent with market practice for a wide variety of fixed investment trusts, the Service believed instead that the use of that method was inconsistent with the substantive rules applicable to fixed investment trusts.

54fff Treasury Regulation § 1.671-5(g)(1)(iv)(A). Trustees of WHMTs with a start-up date prior to August 13, 1998, are exempt from the general requirement to provide OID information. Treasury Regulation § 1.671-5(c)(2)(ii)(A). In addition, for purposes of calculating the market discount fraction under the WHMT safe harbor in § 1.671-5(g)(1)(v), these trustees may assume that the WHMT is holding mortgages issued without OID. See T.D. 9308, 2007-8 I.R.B. 523.

54ggg Treasury Regulation § 1.671-5(g)(1)(vi). 54hhh Treasury Regulation § 1.671-5(g)(2).

Chapter 14

165

Pending the issuance of additional guidance, a temporary safe harbor applies to WHMTs that fail to qualify for the WHMT safe harbor because they hold interests in another WHMT or a REMIC, or they hold or issue stripped interests. Under the temporary safe harbor, a trustee will be deemed to have met its reporting requirements if it calculates and provides information enabling a beneficial owner to reasonably accurately report the tax consequences of owning the trust interest. OID and market discount information must be provided, and may be calculated in any manner consistent with section 1272(a)(6).54iii

g. Directory of WHMT Trustees and NMWHFITs.

The final regulations, as noted above, oblige a middleman who is last in the chain of intermediaries making payment to a TIH to file a Form 1099 and furnish an information statement to the TIH. In order to enhance a middleman’s ability to obtain the trust information necessary to comply with this obligation, the IRS has proposed to expand Publication 938, “Real Estate Investment Conduits (REMICs) Reporting Information (and other Collateralized Debt Obligations (CDOs)),” or to create a separate publication to list WHMT trustees and NMWHFITs.54jjj NMWHFIT trustees will be required to file Form 8811, or a similar form to provide the IRS with the information it needs to list NMWHFITs in the directory. The directory will also alphabetically list WHMT trustees and provide the address of the internet website that lists the WHMTs for which the trustee acts. WHMT trustees will be required to file Form 8811, or a similar form, to identify themselves to the IRS as a WHMT trustee and provide an internet website that lists the WHMTs for which the trustee acts. The IRS and Treasury have received comments in this area, and continue to consider how a directory of WHFITs could be implemented. Pending the publication of such a directory, trustees must provide information regarding a trust representative to call to request the relevant tax information.54kkk

3. Grantor Trusts That Are Not WHFITs

A domestic grantor trust that is not subject to the special reporting rules for WHFITs (because it is not a WHFIT or those rules are not yet effective) is required to file an annual trust information return (essentially, a blank return on Form 1041, the trust income tax return, accompanied by an attachment which identifies trust beneficiaries and allocates income among them).54lll The trust must also send summaries of the information on the return to holders of pass-

54iii Treasury Regulation § 1.671-5(h). 54jjj Proposed Regulation § 1.671-5(c)(5)(iv); T.D. 9308, 2007-8 I.R.B. 523. 54kkk T.D. 9308, 2007-8 I.R.B. 523; see footnote 54o above, and accompanying text. 54lll Treasury Regulation § 1.671-4(a). The requirement for a trust to file Form 1041 is found in

Treasury Regulation § 1.6012-3(a)(1) (see also the cross-reference to Treasury Regulation § 1.671-4 in Treasury Regulation § 1.6012-3(a)(9)). The return for a year is due by the 15th day of the fourth month after the end of the year (April 15 for a calendar-year trust). A grantor trust does not strictly speaking have a taxable year apart from its owners (cf. Revenue Ruling 90-55, 1990-2 C.B. 161), but the common practice is to file based on a calendar year. An optional alternative method of reporting applies to certain grantor trusts under Treasury Regulation § 1.671-4(b). It contemplates Form 1099 reporting of payments made to trust grantors, either by the trust or by persons making income payments to the trust, in lieu of filing Form 1041. The alternative system would rarely be available to trusts issuing pass-through certificates, because among other things (1) it does not apply if any portion of the trust is owned by a foreign person (see Treasury Regulation § 1.671-4(b)(6)(v)) and (2) it assumes the trustee knows the identity of the ultimate beneficiaries of the trust.

Chapter 14

166

through certificates.54mmm Most pass-though certificates are registered in the name of institutions acting as nominees (directly or through chains of middlemen) for the ultimate investors. There is no mechanism in place for reporting to a trust the identities of the ultimate beneficiaries,54nnn and so, of necessity, the certificate holders listed on the attachment to Form 1041 and entitled to the summaries would be the registered holders.54ooo Payments made to investors are subject to Form 1099 reporting, as described below.

Payments made by a trust to registered holders of pass-through certificates that were reported by the trust in a statement attached to the trust income tax return as described in the last paragraph are not required to be reported again on Form 1099 under section 6049.54ppp Otherwise, payments on pass-through certificates made to persons who are not exempt from information reporting are generally subject to reporting on Form 1099s.

E. REMIC Tax Returns


54mmm Section 6034A(a) requires that the fiduciary of a trust required to file a trust income tax return for

any taxable year, on or before the date on which the return was required to be filed, furnish to each beneficiary (or nominee thereof) (1) who receives a distribution from such trust with respect to such year or (2) to whom any income or other item with respect to such year is allocated, a statement containing such information required to be shown on such return as the Service may prescribe. Apparently, there are no regulations or other guidance implementing section 6034A(a). Specifically, the need to provide summary statements to the persons who are taxable on income from a grantor trust is not mentioned in Treasury Regulation § 1.671-4(a) (which, as discussed in the text accompanying footnote 54lll, above, requires the identification of owners in a statement attached to Form 1041), or in the instructions to Form 1041 (including the instructions to Schedule K-1, which is the schedule used by non-grantor trusts to report tax information to beneficiaries). Treasury Regulation § 1.671-4(d) provides that the statement required to be furnished to grantors pursuant to Treasury Regulation § 1.671-4 must be filed by the date specified in section 6034A, but again there appears to be no such requirement in cases governed by the general rule in Treasury Regulation § 1.671-4(a).

54nnn See footnote 86, below. 54ooo This fact was acknowledged by the Service in the 1998 proposed WHFIT regulations. The

instructions to Form 1041 (2000) state that the attachment to the form reporting income of beneficiaries must give the name, identifying numbers and address of the person(s) to whom income of the trust is taxable (i.e., the ultimate owners). For the reasons given in the text, the practice is to provide such information only for record holders. Section 6034A(a), described in footnote 54lll, above, is more realistic. It states that the information must be provided to “each beneficiary (or nominee thereof).”

54ppp Treasury Regulation § 1.6049-4(c)(2). Although the regulation technically exempts section 6049 information reporting only if the trustee provides each grantor with a Form K-1, the IRS has ruled privately that a separate statement attached to Form 1041 (which is all that is required under Treasury Regulation § 1.671-4(a)) containing substantially similar information to the Schedule K-1 will suffice for this purpose. See P.L.R. 8631047 (May 2, 1986). If the section 6049 exception does not apply, the trustee must report each beneficiary’s income at the pass-through rate, rather than at the gross rate on the underlying receivables (including the funds used to pay for servicing). Treasury Regulation § 1.6049-5(a)(6). The new rules for WHFITs described above in the text require separate reporting of gross income and expenses.

Chapter 14

167

Certain penalties apply if a REMIC return is filed late or any tax amounts due by the REMIC are not timely paid. By far the biggest penalty in practical terms is the risk that no effective REMIC election will be considered to have been made because of the failure to file a timely return. The monetary penalties reflect the fact that a REMIC return is both an information return, reporting income allocated to residual interest holders, and less significantly, a return reporting taxes payable by the REMIC itself. The penalty under section 6698 for the failure of a partnership to file a timely and complete partnership tax return also applies to REMICs (see section 860F(e)). The penalty, in the absence of reasonable cause, is $50 times the number of persons who were partners at any time during the taxable year, for each month (or fraction thereof) up to five months during which the failure continued. For a REMIC, the number of holders of the residual interest is substituted for the number of partners.77a Regarding the REMIC as a taxpayer, section 6651(a) imposes a penalty for the failure to file a tax return when due, unless such failure is due to reasonable cause and not willful neglect, of 5 percent of the tax required to be shown as due on the return for each month or portion thereof during which the failure continues, not exceeding a total of 25 percent. However, if the return is more than 60 days late, the penalty is not less than the lesser of $100 and the balance of tax due on the return.

F. Broker Reporting of Sales and Backup Withholding


The Economic Growth and Tax Relief Reconciliation Act of 2001 reduced the rate of backup withholding tax for payments made prior to January 1, 2011. The rate was first reduced to 30.5 percent for payments made after August 6, 2001 and was further reduced to 30 percent on January 1, 2002. It will be further reduced to 29 percent on January 1, 2004 and 28 percent on January 1, 2006.

H. Offshore Issuers

4. Foreign Trusts

Replace the phrase “a proposed regulation was issued in October 2000” at the top of page 867 with the following: “a regulation was issued in August 2001.”

Replace the first three sentences of footnote 119 with the following:

Treasury Regulation § 301.7701-7(d)(1)(iv)(I), adopted by T.D. 8962, 2001-35 I.R.B. 201 (August 9, 2001). A number of commentators had suggested broadening the exception. For an example, see Letter of Saul M. Rosen on behalf of the Securities Industry Association, “Re: Proposed Regulations Section 301.7701-7(d) and (e),” 2001 Tax Notes Today 70-29 (March 23, 2001). The preamble to the final regulations indicates that relief may be forthcoming at a later point in the form of changes in reporting rules:

Two commentators were concerned about United States investors in widely held fixed investment trusts that are outside the safe harbor provided by § 301.7701-7(d)(1)(iv)(I) and therefore are treated as foreign trusts. These commentators suggested that United States investors in such trusts should not be subject to reporting under section 6048 and to the corresponding penalties in section 6677 for failure to comply with the section

77a Treasury Regulation § 1.860F-4(a).

Chapter 14

168

6048 reporting requirements. A guidance project under section 671 concerning reporting requirements for all widely held fixed investment trusts is currently under consideration. Accordingly, these regulations do not specifically address this issue.

Regulations relating to widely held fixed investment trusts were re-proposed in October 2002 and then issued in final form in January 2006. They basically punt on the treatment of foreign trusts. See Part D, footnote 48 (in this Supplement).

Add the following at the end of Part H.4:

Treasury Form 90-22.1, “Report of Foreign Bank and Financial Accounts” (FBAR), must be filed by certain U.S. persons to report foreign bank accounts or foreign financial accounts (such as a securities or securities derivatives account) if the U.S. person has signature authority over the accounts or a “financial interest” in them and the aggregate amount in the account during a calendar year exceeds $10,000. There are criminal sanctions and severe civil penalties for willful failures to comply. The form must be filed by June 30 to report on accounts in the preceding calendar year. A new version of FBAR posted on the IRS web site on September 30, 2008 treats a United States person who established a foreign trust having a foreign account as having a financial interest in the account if a trust protector has been established. A trust protector is a person who is responsible for monitoring the activities of a trustee, with the authority to influence the decisions of the trustee or to replace or recommend the replacement of the trustee. Such a trust could be used in a securitization. The reporting requirement appears to be limited to the person who establishes the trust and not successors (e.g., purchaser of outstanding pass-through certificates). For an article discussing the FBAR requirement (as revised), see Scott D. Michel, “IRS Issues Revised Foreign Account Reporting Form,” 2008 Tax Notes Today 200-44 (October 15, 2008).

Add the following new subsection 5. at the end of Part H.

5. Foreign Disregarded Entities

At the beginning of 2004, the IRS announced that, effective for annual accounting periods of tax owners beginning on or after January 1, 2004, a new information reporting return, Form 8858, must be filed as an attachment to returns of the filer, reporting information with respect to an entity that is disregarded as separate from its owner for U.S. income tax purposes and that is created or organized in a foreign jurisdiction (a foreign disregarded entity or FDE).130a The reporting requirement will be imposed on U.S. persons that are tax owners of FDEs and also on U.S. persons owning certain interests in controlled foreign entities that are tax owners of FDEs. The form generally requires identifying information for the FDE, its legal owners and its tax owner, a U.S. GAAP income statement and balance sheet, information relating to foreign exchange gains and losses from branch transactions, responses to specific yes/no questions regarding equity interests held by the FDE and certain corporate actions, information relating to earnings and profits or taxable income, and for each FDE that is owned by a controlled foreign corporation or partnership, information relating to transactions between the FDE, its tax owner and U.S. persons holding at least a 10 percent interest in the tax owner (but stating that information regarding transactions between an FDE and its tax owner, or between or among FDEs of the same tax owner, is not requested, except where such information is required to administer provisions of the tax law that recognize inter-branch transactions, such as the foreign

130a See Announcement 2004-4, 2004-4 I.R.B. 357.

Chapter 14

169

currency rules). The required information differs depending on who is filing the form. There is as yet no comparable reporting requirement for domestic disregarded entities.

I. Borrower and Miscellaneous Income Reporting

Add the following after the phrase “February 28” in the text accompanying footnotes 135, 142, and 146:


Add the following as a new footnote 144a at the end of the second sentence following the reference in the text to footnote 144:

Generally, under section 108, a borrower recognizes discharge of indebtedness income to the extent the indebtedness is settled for less than its principal amount. To alleviate the effects of foreclosures on individuals, the Mortgage Forgiveness Debt Relief Act of 2007 (PL 110-142, 2007 HR 3648) amended section 108 to permanently exclude from gross income COD income on a principal residence. The exclusion is available for “qualified principal residence indebtedness,” on amounts up to $2,000,000. The Emergency Economic Stabilization Act of 2008 extended this provision to indebtedness discharged prior to January 1, 2013 (and on or after January 1, 2007). Section 108(a)(1)(E). The borrower’s basis in the residence would be reduced by the amount excluded from income. Section 108(h)(1). The Mortgage Forgiveness Debt Relief Act of 2007 also extended the date through which mortgage insurance premium is treated as interest for amounts paid or accrued through, and allocable to periods on or prior to, December 31, 2010. Under Treasury Regulation § 1.6050P-1(a)(3), however, any discharge of indebtedness income generally must be reported regardless of whether the borrower is subject tax on such amount. Notably, the amount of the exclusions may be taxable for state and local income tax purposes.

Add the following comment to the discussion of section 6050P on pages 872 and 873:

In an information letter (INFO 2005-0207, October 7, 2005), the IRS answered a number of general questions about section 6050P reporting. The IRS confirmed that section 6050P may apply to an entity that engages only in acquisitions of delinquent debt and does not originate loans. The letter also states that the IRS does not view filing Forms 1099-C showing discharge of indebtedness income as indicating that debt can no longer be collected, because regulations under section 6050P deem a discharge of debt to have occurred when certain identified events take place solely for purposes of reporting cancellation of indebtedness income, whether or not an actual discharge has occurred.


The IRS suspended penalties for non-compliance with section 6050P with respect to lending organizations that were first required to report by TREA 1999 for discharges of indebtedness occurring prior to the first calendar year beginning at least two months after the date that guidance on the new rules was issued. See Notice 2001-8, 2001-4 I.R.B. 374 (January 22, 2000). In October 2004, the IRS issued Treasury Regulation § 1.6050P-2, effective for discharges of indebtedness occurring on or after January 1, 2005, which generally provides that lending of money is a significant trade or business if money is lent on a regular and continuous basis, subject to safe harbor exceptions for lenders with small amounts of income from lending or just beginning a lending business. Lending money for these purposes includes acquiring

Chapter 14

170

indebtedness, not only from the debtor at origination, but also from a prior holder of the indebtedness. If the principal trade or business of an organization is selling non-financial goods or providing non-financial services, then extending credit to buyers of those goods and services is not a significant trade or business of lending money. According to the preamble, the seller financing exception is not available to separate finance companies that extend credit to customers of affiliates.


Under Treasury Regulation § 1.6050P-1(e)(5), applicable to discharges of indebtedness occurring after December 31, 2004, an entity formed or availed of by an applicable entity for the principal purpose of holding indebtedness originated or acquired by the applicable entity is considered to have a significant trade or business of lending money. This rule may apply to REMICs or other securitization vehicles, but for any such vehicle used in a conventional securitization, the bad intent test would not be met.145a


T.D. 9430 amends the list of identifiable events in Treasury Regulation § 1.6050P-1(b)(2)(iv) to eliminate, for certain applicable financial entities, a presumption (rebuttable by showing that a creditor has engaged in significant, bona fide collection activity) that an identifiable event has occurred when payments have not been received for 36 months. The change applies, effective November 10, 2008, to an organization that is an applicable financial entity because it is engaged in a significant money lending business.


If a transferee entity is required to report discharges of indebtedness under Treasury Regulation § 1.6050P-1(e)(5), then other persons that are considered creditors with respect to the debt held by the entity (for example, the partners, if the entity is a partnership) are relieved of a duplicative reporting requirement. Treasury Regulation § 1.6050P-1(e)(2)(v).

Add the following new paragraph to the text immediately prior to the first full paragraph on page 873:

Section 6050S requires any person who in any calendar year in the course of a trade or

business receives $600 or more in interest from any individual on any “qualified education loans” to report to the Service (on Form 1098-E), among other items, the aggregate amount of interest received. For any calendar year, this form must be filed on or before February 28 (March 31, if

145a The preamble to the prior proposed regulation indicates that this rule prevents a reporting person

from relying on the fact that regulations for REMICs and pass-through securitized indebtedness arrangements are reserved (see footnote 148 below) to conclude that reporting is not required for loans transferred to a REMIC or such an arrangement.

Chapter 14

171

filed electronically) of the following year and a copy of the form (or an alternative statement) must be furnished to the payor by January 31 of the following year.148a

Replace the first sentence of footnote 149 with the following:

Although income on a notional principal contract is determined under an accrual method for all taxpayers, payments are reported only when made (except that deemed interest payments arising from significant nonperiodic payments are reported when deemed made). For this and other rules applicable to notional principal contracts, see Treasury Regulation § 1.6041-1(d)(5).

Add a new Part J at the end of the chapter:

J. Tax Shelter Reporting and Related Measures

For some time, the Code has imposed tax shelter registration and listing requirements. Under section 6111, a tax shelter organizer was required to register a tax shelter with the Service. Organizers or sellers of interests in a potentially abusive tax shelter were required by section 6112 to maintain investor lists open to inspection by the government. The obvious purpose of these sections was to give the IRS a road map leading to tax shelter transactions and affected taxpayers.

Traditionally, tax shelter rules have been a matter of almost complete indifference to participants in securitization transactions. Conventional securitizations are not tax shelters, as that term is understood by laypersons and as it has traditionally been defined for purposes of sections 6111 and 6112. As a result of recent changes in law, however, tax shelter reporting obligations now apply to a new class of reportable transactions. That term cuts a broad swath and may encompass some securitization transactions.

The trouble started in February 2000, when the IRS issued regulations under section 6011 that required corporate taxpayers participating in certain reportable transactions to attach a statement describing the transaction to tax returns for each year in which the taxpayer’s tax liability was affected by the transaction.151 A reportable transaction was not the same as a tax shelter or abusive tax shelter for purposes of sections 6111 and 6112. To make a long story short, the original definition did not encompass conventional securitization transactions. The regulation was amended several times. The current definition is summarized below.

In March 2002, the Treasury expressed its displeasure with the overall state of tax shelter reporting and proposed a new approach with the following elements:152

• a broader, more objective definition of reportable transaction that would potentially catch more evil-doers at the cost of catching angels as well,

148a See Treasury Regulation §§ 1.6050S-3 and -4T. Section 6050S(e) defines a qualified education

loan through cross-reference to section 221(d)(1). That section, in turn, defines such a loan (broadly) as one incurred to pay certain higher education expenses of a student carrying at least half of a full-time work load.

151 Treasury Regulation § 1.6011-4. 152 The broader reporting rules were included in an announcement describing a number of

enforcement proposals. The announcement (entitled “The Treasury Department’s Enforcement Proposals for Abusive Tax Avoidance Transactions”) is available at http://www.ustreas.gov/press/releases/docs/enforcement.pdf.

Chapter 14

172

• coordination of tax return disclosure, listing, and registration rules by having the definition of reportable transaction apply in all three settings,

• an extension of tax return disclosure requirements to individuals, partnerships, and trusts,

• an extension of investor listing requirements to “material advisors” (defined, now under Treasury Regulation § 301.6112-1(c)(2), to include any person (1) required to register a transaction under section 6111 or (2) who makes a tax statement (i.e., a statement that relates to a tax aspect of a transaction that causes the transaction to be a reportable transaction or a tax shelter subject to registration) and receives a minimum fee), and

• significantly increased penalties for non-compliance.

The Treasury’s approach has now been fully implemented through regulations (specifically several versions of regulations relating to tax return disclosure and listing) and changes to the Code included in AJCA 2004 (mostly enhanced penalties, but also changes in sections 6111 and 6112 to have them apply to material advisors). A summary of current law follows. The summary is not comprehensive and highlights only issues that could be significant in the securitization area.

The key to the new system is the definition of reportable transaction, which is found in regulations under section 6011. The discussion herein is based on the most recent of many versions of the regulations, adopted by T.D. 9350 in August 2007 and generally effective August 3, 2007. There are now five categories of transactions with detailed rules for implementing each.153 A reportable transaction is a:

• listed transaction (a transaction identified as a reportable transaction by the IRS in a notice or announcement) or substantially similar transaction,

• confidential transaction, in which the taxpayer pays a minimum fee to an advisor and the advisor places a limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction which protects the confidentiality of that advisor’s tax strategies,

153 See Treasury Regulation §§ 1.6011-4(b)(2) (listed transactions), (3) (confidential transactions), (4)

(transactions with contractual protection), (5) (loss transactions), (6) (transactions with a significant book-tax difference), and (7) (transactions involving a brief asset holding period). (As discussed in the preamble to this Supplement, proposed regulations would add a new reportable transaction category for the payment of fees for the use of certain tax strategy patents, but hopefully patents of that type (and the accompanying reporting requirement) will be curbed through legislation.) The authority to define a reportable transaction under regulations is now granted expressly to the IRS by section 6707A(c)(1) enacted by AJCA 2004. It defines a reportable transaction as “any transaction with respect to which information is required to be included with a return or statement because, as determined under regulations prescribed under section 6011, such transaction is of a type which the Secretary determines as having a potential for tax avoidance or evasion.” A listed transaction is defined in section 6707A(c)(2) as “a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.”

Chapter 14

173

• transaction with contractual protection (where fees, which are paid by the taxpayer to persons making statements about tax results of a transaction, are refundable or contingent if intended tax consequences are not sustained),

• loss transaction (a transaction that is expected to generate section 165 losses that equal or exceed: $10 million in a single taxable year or $20 million in any combination of taxable years for corporations or for partnerships having only corporations as partners; $2 million in any single taxable year or $4 million in any combination of taxable years for individuals, S corporations, trusts, or all other partnerships), or

• a transaction of interest (defined as a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by published guidance as a transaction of interest).

The transaction of interest category may be thought of as “listed transaction light.” It is a category of transaction which may or may not achieve the tax consequences intended by the participants but about which the IRS wants additional information. The new category may apply to transactions entered into on or after November 2, 2006, the date of issuance of proposed regulations introducing the concept.

The regulations previously included transactions with a significant book-tax difference and transactions generating tax credits with a short holding period. The book-tax difference category was eliminated effective for transactions that would otherwise need to be disclosed under the reportable transaction rules or on new schedule M-3 (an enhanced tax return schedule showing book-tax differences) on or after January 6, 2006, principally on the ground that adequate information about book-tax differences will be reported routinely on new schedule M-3.154 The short holding period rule was aimed mostly at foreign tax credits and was no longer needed due to the enactment of limitations on credits in transactions with short holding periods (sections 901(k) and 901(l)).

The regulations are accompanied by a number of revenue procedures (which are described below to the extent they are relevant to securitizations), limiting the types of transactions that must be reported.

The relevance of these categories to securitizations is discussed below.

Listed Transactions. None of the currently listed transactions involve securitizations (the current list is available on the IRS web site at www.irs.gov).155

154 The book-tax category was removed by Notice 2006-6, 2006-5 I.R.B. 385. 155 Notice 2002-35, 2002-1 C.B. 992, identifies as a listed transaction a transaction that uses a

notional principal contract to claim current deductions for periodic payments made by a taxpayer while disregarding the accrual of a right to receive contingent payments in the future. There has been some doubt about when swap transactions with contingent payment features were similar enough to the transaction described in the Notice to be considered listed transactions, and these doubts led to over-reporting. To reduce the flood of paper, the IRS issued Notice 2006-16, 2006-9 I.R.B. 538, which carves out of the scope of Notice 2002-35 contingent payment swaps that do not involve inappropriate timing (e.g., because the taxpayer is accruing income in respect of a contingent leg, is on mark to market, or is using an approved hedging or integration method). Most swaps used in securitizations are conventional interest rate swaps that produce current

Chapter 14

174

Confidential Transactions. Securitizations could involve confidentiality agreements and qualify as reportable transactions that way, although such agreements are relatively rare, and obviously do not exist for investors in publicly offered securities. The scope of this category of reportable transaction was significantly narrowed in December 2003 so that it does not apply to confidentially agreements between principals but only to conditions of confidentiality imposed by an advisor who receives fees above specified thresholds to protect the advisor’s tax strategies. The minimum fee is $250,000 for corporate taxpayers (or partnerships or trusts wholly owned by corporations), and otherwise $50,000. Fees paid to advisors are broadly defined to include payments made in a disguised form or through intermediaries, but do not include amounts paid to a person as a principal in a transaction (for example, as a reasonable charge for the use of capital or the sale or use of property).

Transactions with Contractual Protection. It is rare in securitization transactions for taxpayers to pay traditional fees for services that are conditioned on achieving certain tax results. Commonly, sellers of REMIC residual interests pay consideration (sometimes described as an inducement fee) to buyers to induce the buyers to acquire those interests and suffer the associated tax consequences. Sales are often made under contracts that include tax-related representations made by the buyer (potentially tax statements) that are intended to ensure compliance with safe harbor rules in the REMIC regulations. If those representations are false, and as a result, the intended sale is ineffective, the seller will have a claim against the buyer for damages measured by the tax cost to the seller of continuing to hold the residual interests.

Sales contracts sometimes go further and require the buyer to indemnify the seller against taxes imposed on the seller if the intended transfer is ineffective for any reason. Based on the fact that the buyer might have to pay back some amount to the seller if the sale is ineffective to compensate the seller for the adverse tax consequences, arguably, the inducement fee is conditioned on the realization of tax benefits by the seller. The regulations do not require explicitly that a fee be paid for services but only that it be paid to a person who makes a tax statement. That said, the implication is that a fee does not include amounts paid for acting as a principal in a transaction, and an inducement fee is such an amount. Although the regulations could be clearer, the authors understand from informal conversations with the Service that they did not intend to treat as a reportable transaction routine sales of REMIC residual interests. Indeed, the Service provided an explicit carve-out from the definition of a loss transaction for losses from the sale of REMIC residual interests (see below), which would be at the least misleading if the transactions were otherwise routinely considered reportable transactions in the contractual protection category. It would be nice if the Service clarified the language, but in the meantime, the practice is firmly established not to treat such sales as reportable transactions.156

Loss Transactions. Transactions with REMIC residual interests are often expected to generate eventual losses from the reversal of phantom income. The IRS has issued a revenue

accruals of income or deductions and do not pose a problem under the 2002 Notice. Credit default swaps, which are also used in securitizations, also would not seem to pose a problem under the 2002 Notice, assuming they are treated as notional principal contracts. Payments by the protection seller upon a credit event generally are not expected in any amount when the contract is entered into, and the protection provided by the swap can be said to accrue over time in tandem with the payments made by the protection buyer.

156 Revenue Procedure 2004-65, 2004-50 I.R.B. 965, limits the contractual protection category in ways not relevant to securitizations.

Chapter 14

175

procedure157 which allows certain losses to be ignored in applying the loss transaction definition. The list of excluded losses includes a loss attributable to basis increases under section 860C(d)(1) during the period of the taxpayer’s ownership. That section increases the basis of a REMIC residual interest by the amount of undistributed taxable income reported by the holder. Accordingly, losses from residual trading should not trigger a reporting requirement.158

Transactions of Interest. The IRS has not yet identified any transaction relating to securitizations as a transaction of interest.

Transaction with a Significant Book-Tax Difference. The following discussion is relevant only for transactions for which reporting is required prior to January 6, 2006, the effective date of the elimination of the book-tax factor.159

Securitizations can involve various book-tax differences, primarily affecting the sponsors. For example, such a transaction may be undertaken in a way that achieves off-balance sheet treatment for the sponsor for accounting purposes but not for tax purposes, or sales treatment for one purpose but financing treatment for another purpose. At one point at least, it was popular to report different gain amounts for tax and book purposes using different allocations of cost. Thus, it is worth considering whether the book-tax difference category applies to securitization transactions.

A transaction has a reportable book-tax difference where the amount for tax purposes of any item or items of income, gain, expense, or loss from the transaction differs by more than $10 million on a gross basis from the amount of the item or items for book purposes in any taxable year. Book items are generally determined under U.S. GAAP (or if the taxpayer does not maintain U.S. GAAP books, using the books consistently maintained by the taxpayer). The book-tax difference category applies only to taxpayers that are reporting companies under the Securities Exchange Act of 1934 and certain related business entities or business entities having more than $250 million in gross assets for book purposes (including assets of related persons).

The regulations provide that for purposes of determining book-tax differences, book items of a disregarded entity or partnership are attributed to the owner or partners (so that the fact that the 157 Revenue Procedure 2004-66, 2004-50 I.R.B. 966, modifying and superseding Revenue Procedure

2003-24, 2003-1 C.B. 599. 158 Note that the exception applies only to basis increases during the period of “the taxpayer’s

ownership.” Accordingly, it would not seem to cover a case in which a taxpayer acquired a residual interest from another taxpayer in a carryover basis transaction. For a discussion, see Chapter 9, Part E.4.i (in this Supplement). The revenue procedure also includes a general exception for losses from the sale or exchange of an asset with a “qualifying basis,” which is, generally, the basis resulting from a cash purchase of property. However, the exception does not apply to an interest in a “passthrough entity” within the meaning of section 1260(c)(2) (which includes partnerships, trusts, PFICs and REMICs), other than REMIC regular interests (meaning that they can qualify for the exception). The PFIC exception would be relevant to investors in stock of offshore issuers (see Chapter 13). There are also exceptions for a loss arising from marking an asset to market, although it requires that the loss be computed (for the first mark) using a qualifying basis, a loss arising from a hedging transaction described in section 1221(b) (generally hedges of ordinary liabilities or ordinary assets) if the taxpayer properly identifies the transaction as such, and a loss equal to and determined solely by reference to a cash payment (such as a payment made upon cash settlement of a derivatives contract).

159 See footnote 154, above, and accompanying text.

Chapter 14

176

entity or partnership maintains separate books does not create a reporting obligation). Also, differences from transactions between a disregarded entity and its owner are ignored. There is no explicit rule for grantor trusts comparable to the one for disregarded entities, although it would be difficult to justify a different approach. The fact that a subsidiary is consolidated for book but not tax purposes does not create a reportable difference.160

The IRS has issued a revenue procedure161 which sets out certain book-tax differences that do not give rise to a reporting requirement. Excepted items that may be relevant to securitizations include the following: items producing greater taxable income than book income or taxable income before book income, bad debts or cancellation of indebtedness, items resulting from debt-for-debt exchanges, items resulting from treatment as a sale, purchase, or lease for book purposes but as a financing arrangement for tax purposes,162 items resulting from the treatment of an exchange of mortgages as a nonrecognition exchange for tax purposes under section 860F(b)(1)(A) but as a sale for book purposes (not including differences resulting from the application of different valuation methodologies to determine the relative value of REMIC interests for purposes of allocating basis), items resulting from differences in hedge accounting, items resulting from integration of a debt instrument and hedge for tax purposes but not book purposes, items resulting from differences in mark-to-market accounting, items resulting from the application of the bond stripping rules in section 1286, gains and losses arising under sections 986(c), 987 and 988 (dealing with nonfunctional currencies), and a broad category of items that are reported on a gross basis for book purposes and a net basis for tax purposes, or vice versa, if the differing reporting produces no net book-tax difference for the taxable period (e.g., reporting of income from a pass-through certificate at the pass-through rate for book purposes and as gross interest less a deduction for servicing fees for tax purposes).

A determination that a transaction is a reportable transaction has the following main consequences:

• The taxpayer participating in the transaction must report the transaction on Form 8886 (“Reportable Transaction Disclosure Statement”) by attaching it to his tax return. See Treasury Regulation § 1.6011-4. Section 6707A, added to the Code by AJCA 2004, imposes penalties for failing to disclose reportable transactions as required under these regulations (the penalties are particularly high in the case of listed transactions), and requires that the imposition of certain penalties be disclosed in reports filed with the SEC for SEC reporting companies.162a

160 This last rule is found in the definition of participation in Treasury Regulation § 1.6011-

4(c)(3)(i)(E). 161 Revenue Procedure 2004-67, 2004-50 I.R.B. 967, modifying and superseding Revenue Procedure

2003-25, 2003-1 C.B. 599. 162 For an example, see the discussion of credit card securitization trusts in Chapter 3, Part E.4. Note

that there is no exception for transactions treated as sales for tax purposes but financings for book purposes (for example, a sale of property with a put back to the seller). For a discussion of different standards of tax ownership for tax and book purposes, see Chapter 3, Part C. The rule discussed below in the text disregarding differences arising from treating two items as gross items for one purpose and net items for the other purpose so long as the net amount is the same also may be helpful in cases where transactions are characterized differently for book and tax purposes.

162a Revenue Procedure 2007-21, 2007-9 I.R.B. 613, provides guidance for taxpayers and material advisers who seek rescission of a section 6707 or section 6707A disclosure penalty if the penalty

Chapter 14

177

• Any “material advisor” with respect to a reportable transaction must report the transaction to the IRS soon after it happens. See section 6111 (reporting requirement) and section 6707 (penalties, which are similar to the penalties imposed on taxpayers failing to disclose), both as revised by AJCA 2004. A material advisor also must maintain for inspection by the IRS a list identifying each person with respect to whom the material advisor acted as a material advisor with respect to the transaction. See section 6112 (list maintenance requirement) and section 6708 (penalties of $10,000 per day for failure to provide list to IRS within 20 business days following a request), again as revised by AJCA 2004. A material advisor is generally defined as a person who makes a tax statement and receives a minimum fee.163

• A 20 percent penalty (30 percent for undisclosed transactions) applies under section 6662A (added by AJCA 2004) to any listed transaction or any other reportable transaction with a significant tax avoidance purpose. The ability of a taxpayer to avoid the penalty based on good faith and reasonable cause is limited by new section 6664(d) (again added by AJCA 2004), which among other things requires that the transaction have been properly disclosed on a return, requires that the taxpayer reasonably believed at the time of filing of a return that the position it took was more likely than not the proper treatment, and provides that a taxpayer may not rely on a tax opinion to establish such belief unless the opinion meets certain requirements and comes from a disinterested tax advisor (one who is not “disqualified”). A law firm that performs corporate work on a transaction and receives a minimum fee would be disqualified.

To round out the story about anti-shelter measures taken by the government, in December 2004 and May 2005, the IRS issued revised regulations under Circular 230 regulating written tax advice, including informal advice, given by practitioners authorized to practice before the IRS.164 The new rules apply to written advice rendered after June 20, 2005. With some exceptions, a practitioner may be censured, suspended or disbarred from practice before the IRS (and under future regulations, may be subject to fines) for violating the new rules willfully or recklessly or through gross incompetence.165

relates to a reportable transaction other than a listed transaction. Temporary regulations regarding the imposition of penalties under section 6707A were adopted by T.D. 9425. They are effective September 11, 2008.

163 See Treasury Regulation § 301.6111-3(b) (as revised by T.D. 9351, August 3, 2007). For prior guidance implementing AJCA 2004 changes, see Notice 2005-22, 2005-12 I.R.B. 756, Notice 2005-17, 2005-8 I.R.B. 606, and Notice 2004-80, 2004-50 I.R.B. 963. Treasury Regulation § 301.6111-3(b)(4) treats a person as becoming a material advisor no earlier than the date on which the taxpayer enters into the reportable transaction. Treasury Regulation § 301.6111-3(d) requires that the reporting form (Form 8918, “Material Advisor Disclosure Statement”) be filed no later than the last day of the month following the end of the calendar quarter in which the advisor became a material advisor.

164 See T.D. 9201, 2005-23 I.R.B. 1153 (May 18, 2005), and T.D. 9165, 2005-4 I.R.B. 357 (December 20, 2004).

165 Section 822 of AJCA 2004 amends section 330 of Title 31 to authorize the imposition of monetary penalties for violations of Circular 230 (up to the amount of gross income derived from the conduct giving rise to the penalty; firms employing practitioners may be subject to the penalties) and to provide that “[n]othing in this section or in any other provision of law shall be construed to limit the authority of the Secretary of the Treasury to impose standards applicable to the rendering of written advice with respect to any entity, transaction, plan or arrangement, or other plan or

Chapter 14

178

The most controversial part of the package is a new section 10.35, which defines the term “covered opinion” and generally requires that a covered opinion be a “full-blown” tax opinion that recites relevant facts and expresses a view on all relevant significant tax issues. In some cases, the status of advice as a covered opinion can be avoided by including in the advice a warning label to the effect that the advice was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties (and in the case of advice used or referred to in promoting or marketing a transaction, that the advice was written to support such promotion or marketing and the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor). There is also an exception for advice included in documents required to be filed with the SEC and for certain preliminary advice.

A complete description of the Circular 230 changes is beyond the scope of this book. However, in brief, the rules would not apply to securitizations unless it could be said that they were part of a plan or arrangement having a significant purpose of avoiding or evading federal tax. In fact, securitizations are undertaken in almost all cases for entirely commercial reasons, and the tax planning is defensive (to avoid incremental taxes that the economics could not tolerate) and in accordance with the relevant Code provisions and legislative intent. Accordingly, is it very unlikely that the significant purpose test would be met with respect to a conventional securitization. Nevertheless, because the significant purpose-tax avoidance phrase is somewhat vague, and as an anodyne to the pain of reasoning, the initial reaction of the securitization tax bar to the amendments seems to be to treat securitizations across the board as if they were or could be significant purpose transactions. In practical terms, this means sprinkling warning labels throughout disclosure statements and opinions. This development would be quite unfortunate if it had the practical effect of depriving taxpayers of protection from penalties. On the other hand, for most securitizations, the risk that expected tax consequences will not be achieved is quite small, and penalties are not on the table unless the IRS first determines that a tax deficiency is due.

Finally, the Small Business and Work Opportunity Tax Act of 2007 (Public Law 110-28) amended section 6694 to raise the standard needed for tax return preparers to avoid penalties for understatements on returns they prepare. As revised, penalties may apply to a position unless either there was a reasonable belief that the position would more likely than not be sustained on its merits, or there was a reasonable basis for the position and it is disclosed on the return. Prior law required only that a position have a realistic possibility of being sustained on its merits (or be disclosed and not frivolous). Also, the 2007 legislation increased the penalties (to the greater of a fixed dollar amount or 50 percent of the income earned from preparing the return).166 The Emergency Economic Stabilization, Energy Improvement and Extension, and Tax Extenders and AMT Relief Acts of 2008 further amended section 6694 to replace the general more likely than not test with one that requires that a position have substantial authority.

H. Offshore Issuers

2. Foreign Corporations

arrangement, which is of a type which the Secretary determines as having a potential for tax avoidance or evasion.” Note that this last grant of authority is not by its terms limited to advice given by practitioners authorized to practice before the IRS.

166 On September 24, 2007, the IRS issued proposed amendments to Circular 230 that would amend the minimum professional standards that must be met by return preparers to conform such standards to the 2007 changes to section 6694.

Chapter 14

179

The regulations under section 6038 and 6038A have been updated and corrected in some fairly minor ways. See T.D. 9268, 2006-30 I.R.B. 94, and T.D. 9338, 2007-35 I.R.B. 463.

180

Chapter 15 Taxation of Sponsors

B. Sponsors That Are Loan Servicers, Securities Dealers, or Members of Consolidated Groups

3. Intercompany Transactions

Add the following at the beginning of footnote 11:

Income deferred under the installment sale rules (which for dealers, under current law, is limited to sales of certain farms and time share interests) would also be triggered by the transfer of the related receivable to a TMP.

C. Pass-Through Certificates

1. Issuer Classified as Trust


The allocation of basis in proportion to fair market value could result in the creation of discount with respect to a subordinated class if that class has a lower fair market value compared with its principal amount than the senior class. A question then arises whether such new discount is market discount within the meaning of section 1278(a)(2). (The treatment of market discount is discussed in Chapter 8, Part E.) This section defines market discount as the excess of the stated redemption price of a debt instrument at maturity over its basis “immediately after its acquisition by the taxpayer.” While not entirely clear, a subordinated interest in a debt instrument should not be considered to be newly acquired solely on account of the sale of a senior interest in the same instrument. Accordingly, it would seem that discount arising from an allocation of basis should not be considered market discount (although it would be in the hands of a transferee). An analogous situation arises where payments on a debt instrument are deferred in a way that would increase discount on the instrument if it were newly issued (by converting qualified stated interest into OID) but the deferral does not give rise to a deemed exchange under section 1001. In such a case, Treasury Regulation § 1.1275-5(f) treats the deferral as causing a deemed retirement and reissuance of the instrument solely for purposes of applying the OID rules. There is no comparable rule under section 1278 that treats a debt instrument as newly acquired for purposes of applying the market discount rules when discount is created through a basis allocation.


Under section 1091(f), the wash sales rules do not fail to apply to a contract or option to acquire or sell stock or securities solely by reason of the fact that the contract or option is, or could be, settled in cash (or other property) rather than such stocks or securities. See Chapter 9, footnote 62 (in this Supplement).

Chapter 15

181

Replace the citation to Compaq Computer Corp. v. Comm’r in foonote 23 with the following:

113 T.C. 214 (1999), rev’d on other grounds, 277 F.3d 778 (5th Cir. 2001).

D. Asset Backed Securities Taxable as Debt

Add the following in footnote 35 after the third sentence in the footnote:

The consequences of treating a purported financing as a sale can be particularly awful if the receivables represent future operating revenues from a business that have not yet been taxed. A sale would result in income equal to the full proceeds of the debt. Examples of securitizations involving future revenues include financings of: (1) stranded costs by utilities (see Chapter 3, Part D.1.k (in this Supplement)), (2) rights to legal fees in tobacco litigation by lawyers and (3) so-called “12b-1 fees” (certain sales commissions paid over time by mutual funds).

E. REMICs


A REMIC sponsor would realize a smaller amount of gain upon a sale of REMIC interests if retained interests were assigned a lower value, because the lower valuation would result in a higher allocation of the sponsor’s basis in the mortgages contributed to the REMIC to the interests that are sold. According to a Tax Analysts report summarizing comments by two IRS officials speaking on October 11, 2007 at an IRS financial services conference sponsored by Tax Executives Institute, the IRS believes some sponsors have undervalued retained interests significantly by using overly bearish assumptions in the models used to value the retained interests. The potential adjustments could be very large. The officials indicated that some sponsors had used default assumptions that were 10 times the historical average. The officials said that sponsors should not expect relief due to the subprime mortgage crisis because the recent experience does not justify the assumptions used in earlier years, and many of the affected REMICs do not hold subprime loans. See Dustin Stamper and Lee A. Sheppard, “IRS Cracking Down on Billions in Mortgage Securities Evasion,” 2007 Tax Notes Today 198-1 (October 12, 2007). See also, Lynnley Browning, “IRS Looks at Mortgage Securities,” New York Times (October 13, 2007).

In September 2008, the IRS identified allocations between retained and sold REMIC interests as a “Tier III” audit issue (Tiers I and II are worse, but III still requires industry coordination). The announcement describes the issue as follows:

The Service is looking into the issue of REMIC sponsors’ understatement of reportable gain on the retention and the sale of regular interests. Under the statutory and regulatory scheme, undervaluing REMIC regular interests retained by the sponsor results in a change in the relative allocation of basis to all the other REMIC regular interests under the proportionate to fair market value basis allocation formula. The Service will be reviewing the sponsor’s economic models and assumptions (such as the loss rate, the prepayment rate, and the discount rate) used to value the residual interests in order to determine if the fair market value and basis allocations are appropriate for the retained regular interests.

Chapter 15

182

On page 898, in the last sentence of the chapter, replace the phrase “original issue discount” with:

market discount (and the holder had made an election to include market discount in income as it accrues)

183

Chapter 16 FASITs A. Introduction

The FASIT rules were repealed by section 835(a) of AJCA 2004. The repeal is generally effective January 1, 2005, except that it does not apply to any FASIT in existence on the date of enactment of AJCA 2004 (October 22, 2004) to the extent that regular interests issued by the FASIT before such date continue to remain outstanding in accordance with the original terms of issuance. The “to the extent” language is not altogether clear. Specifically, it could be read to mean that a FASIT can continue to operate as originally contemplated (including issuing new regular interests) so long as some amount of enactment-date regular interests remain outstanding. Alternatively, it could be meant to grandfather a FASIT only in part, to the extent it is funded with those regular interests. The legislative history does not clear up the ambiguity. It is fitting that the transition rule is unclear, because from beginning to end, almost nothing relating to FASITs has been done right. The events leading to repeal of the FASIT rules are described in the text below. Obviously, final FASIT regulations will never be issued.

The NYSBA Reforms Report issued in December 2002 proposes a number of tax law changes as an alternative to FASITs and recommends that the FASIT rules be repealed (as has now happened). See the Attachment to this Supplement.

The JCT Enron Report issued on February 13, 2003, recommended repeal of the FASIT rules. Following issuance of that report, repeal legislation was incorporated in a number of bills and, as described above, eventually was passed as part of AJCA 2004.

The JCT recommendation was based on the view that the potential abuses of FASITs outweighed the benefits of having them. The committee staff described two transactions, Project Apache and Project Renegade, that involved FASITs. (Perhaps someone thought that a FASIT was a lost Indian tribe.) In Project Apache, Enron established a foreign subsidiary together with a Dutch bank. The subsidiary effectively loaned money back to Enron. Interest deductions on a direct loan would be subject to the earnings stripping limitations in section 163(j) (which generally limits the portion of a taxpayer’s taxable income that can be offset with interest deductions by cutting back deductions for interest paid to related foreign parties that do not bear a U.S. withholding tax). Enron sought to avoid this limitation by having the foreign corporation buy regular interests in a FASIT that, in turn, bought receivables generated in Enron’s business. Enron provided credit support by purchasing subordinated regular interests in the FASIT. The FASIT ownership interest was held by a party unrelated to Enron and had a value that was quite small compared to the overall capital of the FASIT.

In Project Renegade, Enron acted as an accommodation party to allow an unrelated bank to establish a FASIT. Apparently, the purpose of the FASIT was to allow the bank to accelerate gain (perhaps to offset expiring NOLs) by relying on the rule described in Part G.2 (in the book) requiring a FASIT sponsor to recognize gain upon the transfer of assets to a FASIT and to measure such gain, in the case of debt instruments not traded on an established securities market, using an artificially low discount rate. Given that this result is clearly dictated by the statute, it is far from clear that a transaction designed to produce such a gain is abusive. At any rate, the

Chapter 16

184

transaction should serve as a reminder to tax policy makers that any statutory rule that deliberately distorts income or losses has the potential of being used against the government.

In footnote 6, replace “Income” with “Investment” in the title of the cited NYSBA report.

D. FASIT Qualification

2. Assets Test

b. Cash and Cash Equivalents

Add to the end of the footnote 112 on page 945:

Revenue Ruling 66-290 was declared obsolete by Revenue Ruling 2003-99, 2003-34 I.R.B. 388.

G. Taxation of Owner

6. Transfers of Ownership Interests

c. Wash Sale Rule

Add the following as a new footnote 365a at the end of the sentence immediately following the reference in the text to footnote 365:

Under section 1091(f), the wash sales rules do not fail to apply to a contract or option to acquire or sell stock or securities solely by reason of the fact that the contract or option is, or could be, settled in cash (or other property) rather than such stocks or securities. See Chapter 9, footnote 62 (in this Supplement). For a discussion of whether the wash sale rules apply to deductions for inducement payments, see Chapter 9, Part D (in this Supplement).

d. Transfers for Tax Avoidance Purpose


Final regulations were issued. See Treasury Regulation § 1.860E-1; see also Chapter 9, Part E.4.e.(i) (in this Supplement).

H. Special Topics

3. Use in Mortgage Transactions


Treasury Regulation § 1.267(a)-3 was held to be a valid exercise of regulatory authority and not in violation of the anti-discrimination clause of the 1967 United States-France income tax treaty. Square D Co. v. Comm’r, 118 T.C. 299 (2002).

6. Foreign Tax Credit Limitation—Allocation of Interest Expense.

The House Jobs Bill would simplify certain aspects of the foreign tax credit rules.

Chapter 16

185

Add the following new footnote 418a at the end:

Notice 2001-59, 2001-41 I.R.B. 315, asks for comments on whether the definition of “integrated financial transaction” (a type of transaction in which interest expense can be offset directly against income from the transaction for purposes of computing the foreign tax credit limitation; (see Chapter 9, footnote 26, this Supplement) should be expanded. An expansion of the definition would be consistent with the approach of the FASIT regulations in that it would provide for a more direct matching of interest expense against income from related assets where a sufficient connection is established between the assets and the borrowing. One comment letter from General Motors (“General Motors Criticizes Interest Expense Allocation And Apportionment Rules,” 2002 Tax Notes Today 31-33 (January 23, 2002)) supports netting of interest expense of financial service entities against income of such entities and, absent that, netting within off-balance sheet securitization vehicles.

186

Glossary

The following replaces the indicated definition in its entirety:

Backup Withholding: A tax withheld from certain interest and dividend payments, and payments by a broker of the proceeds of a sale of property, usually because of a failure of the payee to furnish a proper taxpayer identification number to the payor. This tax is imposed as a collection device and is fully creditable by the taxpayer. The Economic Growth and Tax Relief Reconciliation Act of 2001 reduced the rate of backup withholding tax for payments made prior to January 1, 2011. The rate will first be reduced to 30.5 percent for payments made after August 6, 2001 and will be further reduced to 30 percent on January 1, 2002, 29 percent on January 1, 2004, and 28 percent on January 1, 2006.

The following are added to the Glossary:

AJCA 2004: American Jobs Creation Act of 2004 (Public Law 108-357), enacted on October 22, 2004, which repealed the FASIT rules and made other changes affecting securitizations.

AJCA 2004 Conference Report: Conference Committee Report accompanying AJCA 2004, H.R. Conf. Rep. No. 108-755, 108th Cong. 2d Sess, as released on October 7, 2004.

Bush 2004 Revenue Proposals: See General Explanations of the Administration’s Fiscal Year 2004 Budget Proposals (Department of the Treasury, February 2003), available at http://w3.access.gpo.gov/usbudget/.

CNPC: A notional principal contract that provides for one or more contingent nonperiodic payments. In February 2004, the IRS issued proposed regulations addressing the treatment of CNPCs.

Credit Swap: See Default Swap.

Credit Default Swap: See Default Swap.

CRTRA 2000: The Community Renewal Tax Relief Act of 2000, Public Law 106-554. As relevant to securitizations, CRTRA 2000 amended the wash sales rules to clarify that they can apply to a contract or option to acquire or sell stock or securities that is, or could be, settled in cash (or other property) rather than such stocks or securities.

Default Swap: A contract, typically written using standardized documentation from ISDA, wherein one party, the protection purchaser, makes periodic payments (based on a notional principal amount) in exchange for a payment from the other party, the protection seller, solely upon the occurrence of a credit event (a default on a reference debt obligation or an insolvency event with respect to a reference obligor). Default swaps are typically settled either: (1) in cash, with a payment equal to the difference between the principal amount of the reference obligation and its post-credit event fair market value (or, in some cases, with a payment of a predetermined fixed amount) or (2) physically, by the delivery of deliverable obligations (either the reference obligation or other obligations of the reference obligor that are expected to approximate the post-

Glossary

187

default value of the reference obligations) in exchange for the principal amount of the reference obligation.

GFM Class: Guaranteed final maturity class, which is a class of REMIC regular interests that benefit from a minimum prepayment guarantee in that they are subject to mandatory retirement by the issuer on a fixed date that is earlier than the date on which the qualified mortgages held by the REMIC would be fully retired if they were not prepaid to any degree. The date typically is set so that the qualified mortgages are expected to be fully retired on or prior to that date based on a reasonable prepayment assumption.

House Jobs Bill: As used in this Supplement, the American Jobs Creation Act of 2004 (H.R. 4520, 108th Cong. 2nd Sess.), as passed by the House of Representatives on June 17, 2004.

Hybrid ARM: An adjustable rate mortgage that provides for automatic conversion of a fixed rate to a floating rate or vice versa.

ISDA: The International Swaps and Derivatives Association, a global trade association representing leading participants in the privately negotiated derivatives industry, a business which includes interest rate, currency, commodity, credit and equity swaps, and related products such as caps, collars, floors, and swaptions.

JCT Enron Report: Joint Committee on Taxation Staff, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03) (February 13, 2003), available at http://www.house.gov/jct/. The Report discusses structured transactions entered into by Enron to boost GAAP earnings through eventual tax savings, including two involving transfers of high-basis, low-value REMIC residual interests to an Enron subsidiary and two involving FASITs. The Report recommends changes to prevent the duplication of losses and further FASIT abuses.

NIMS: Net Interest Margin Securities, which are pay-through bonds supported by subordinated rights to receive interest spreads in mortgage securitizations. Those rights may be evidenced by REMIC residual interests, IO Interests or IO Strips. NIMS are generally created where the underlying mortgages involve a significant risk of default, so that there is a material spread between the rates of interest on the mortgages and the rates of interest on REMIC regular interests or other senior securities.

NYSBA Reforms Report: A report issued by the New York State Bar Association, Tax Section, in December 2002, making a series of recommendations for changes in the tax law relating to securitizations. The recommendations are summarized in an Attachment to this Supplement. For the full text of the report, see NYSBA, “Securitization Reform Measures,” 98 Tax Notes 795 (February 10, 2003), or the NYSBA Web site at http://www.nysba.org/taxreports/ (report number 1024).

PAYGO swap: A pay-as-you-go swap is a form of swap contract that, like a default swap, shifts credit risk between a protection buyer and seller. The three main differences compared with a conventional default swap are that a PAYGO swap references an identified class of debt (typically an asset-backed security), has a term equal to the remaining maturity of the reference obligation, and in lieu of a one-time physical or cash settlement upon the occurrence of a credit event, requires the protection seller to pay as they occur all or a portion of any shortfall in amounts actually paid on the reference obligation compared to amounts due. A PAYGO swap may be documented as a credit swap or total return swap. In the latter case, the swap may also

Glossary

188

incorporate the economic features of a fixed-floating interest rate swap. In order to avoid characterization as a guarantee or insurance, the typical PAYGO swap does not require the protection purchaser to own the reference obligation.

Stranded Costs: Stranded costs are costs that were incurred by a regulated utility prior to a

switch from a regulated to competitive system for generating and selling electricity and are not expected to be recoverable from customers buying power at market prices. A utility may be granted the right to collect a transition charge from consumers in its service area to compensate it for stranded costs. In a stranded cost securitization, those charges are used to support nonrecourse debt issued by the utility through a special purpose entity.

Reportable Transaction: The term used in Treasury Regulation § 1.6011-4 to describe transactions with tax shelter potential that are subject to special disclosure on tax returns, a requirement to list investors under section 6112 and registration under section 6111.

Securitization Partnership: As defined in section 743(f)(2), means any partnership the sole business activity of which is to issue securities which provide for a fixed principal (or similar) amount and which are primarily serviced by the cash flows of a discrete pool (either fixed or revolving) of receivables or other financial assets that by their terms convert into cash in a finite period, but only if the sponsor of the pool reasonably believes that the receivables and other financial assets comprising the pool are not acquired so as to be disposed of. A securitization partnership is not required to adjust the basis in its assets following (1) a transfer of a partnership interest even if the partnership has a substantial built-in loss in its assets under section 743 or (2) the distribution of property to a partner even if there is a substantial basis reduction under section 734. Following amendments to sections 743 and 734 made by AJCA 2004, such adjustments are generally mandatory except for securitization partnerships and, in the case of section 743, certain electing investment partnerships.

Senate JOBS Bill: As used in this Supplement, the Jumpstart Our Business Strength (JOBS) Act (S. 1637, 108th Cong. 2nd Sess.), as passed by the Senate on May 11, 2004.

Synthetic CBO: A CBO equivalent created by combining a default swap under which a CBO issuer is the protection purchaser with a low-risk third party debt instrument.

Synthetic Collateral: A low-risk debt instrument held by a CBO issuer together with a default swap under which the CBO issuer is the protection seller.

2001 IRS Business Plan: 2001 Priorities for Tax Regulations and Other Administrative Guidance (available at 2001 Tax Notes Today 82-1 (April 26, 2001)). Each year, the Service and the Treasury publish a plan (commonly referred to as the “Business Plan”) identifying projects that the Service expects to complete during the “plan year” (the year ending June 30, which was changed in 2001 from the calendar year).

2002-2003 IRS Business Plan: 2002-2003 Priority Guidance Plan (initially released on July 10, 2002) (an annotated version incorporating three additional quarterly updates is available at 2003 Tax Notes Today 174-6 (September 9, 2003)). See 2001 IRS Business Plan.

2003-2004 IRS Business Plan: 2003-2004 Priority Guidance Plan (initially released on July 24, 2003) (an annotated version incorporating three additional quarterly updates is available at 2004 Tax Notes Today 178-7 (September 14, 2004)). See 2001 IRS Business Plan.

Glossary

189

2004-2005 IRS Business Plan: 2004-2005 Priority Guidance Plan (initially released on July 26, 2004) (as updated on a combined basis for the first and second quarters on December 21, 2004) (available at 2004 Tax Notes Today 246-10 (December 22, 2004) and at www.irs.gov under Tax Professionals, IRS Resources, Administrative Information and Resources, 2004 - 2005 Priority Guidance Plan). See 2001 IRS Business Plan.

2005-2006 IRS Business Plan: 2005-2006 Priority Guidance Plan (initially released August 8, 2005) (available at 2005 Tax Notes Today 152-18 and at http://www.irs.gov/pub/irs-utl/2005-2006pgp.pdf).



2008-2009 IRS Business Plan: 2008-2009 Priority Guidance Plan (initially released September 10, 2008) (available at 2008 Tax Notes Today 177-25 and at http://www.irs.gov/pub/irs-il/2008-2009pgp.pdf).

WHMT: A widely held mortgage trust, which is a WHFIT substantially all the value of the assets of which are mortgages, amounts received on mortgages, and reasonably required reserve funds.

Widely Held Mortgage Trust: See WHMT.

190

Appendix A

State Tax Exemptions for REMICs

STATE COMMENTS AUTHORITY

Add the following to the table in alphabetical order:

Montana Appears to follow federal law. Response to CCH Corporate Income Tax Multistate Survey (July 21, 2003) CCH Montana State Tax Reporter ¶ 400-921

Texas Not subject to tax. Tex. Tax Code Ann.

§ 171.002(c)(9) (Tex. Tax Code Ann. § 171.002(c)(5), effective January 1, 2008)

191

Appendix C

Internal Revenue Code and Regulations

INTERNAL REVENUE CODE

SECTIONS 860A-860G

Section 860G. Other definitions and special rules.

Add the following at the end of section 860G(a)(1) (definition of regular interest):

An interest shall not fail to qualify as a regular interest solely because the specified principal amount of the regular interest (or the amount of interest accrued on the regular interest) can be reduced as a result of the nonoccurrence of 1 or more contingent payments with respect to any reverse mortgage loan held by the REMIC if, on the startup day for the REMIC, the sponsor reasonably believes that all principal and interest due under the regular interest will be paid at or prior to the liquidation of the REMIC.

Add a new section 860G(a)(3)(A)(iii) as follows (addition to definition of qualified mortgage):

(iii) represents an increase in the principal amount under the original terms of an obligation described in clause (i) or (ii) if such increase–

(I) is attributable to an advance made to the obligor pursuant to the original terms of a reverse mortgage loan or other obligation,

(II) occurs after the startup day, and

(III) is purchased by the REMIC pursuant to a fixed price contract in effect on the startup day.

Revise the language at the end of section 860G(a)(3) to read as follows:

For purposes of subparagraph (A) any obligation secured by stock held by a person as a tenant-stockholder (as defined in section 216) in a cooperative housing corporation (as so defined) shall be treated as secured by an interest in real property, and any reverse mortgage loan (and each balance increase on such loan meeting the requirements of subparagraph (A)(iii)) shall be treated as an obligation secured by an interest in real property. For purposes of subparagraph (A), any obligation originated by the United States or any State (or any political subdivision, agency, or instrumentality of the United States or any State) shall be treated as principally secured by an interest in real property if more than 50 percent of such obligations which are transferred to, or purchased by, the REMIC are principally secured by an interest in real property (determined without regard to this sentence).

Revise section 860G(a)(7)(B)(definition of qualified reserve fund) to read as follows:

REMIC Regulations

192

(B) Qualified reserve fund. For purposes of subparagraph (A), the term “qualified reserve fund” means any reasonably required reserve to–

(i) provide for full payment of expenses of the REMIC or amounts due on regular interests in the event of defaults on qualified mortgages or lower than expected returns on cash flow investments, or

(ii) provide a source of funds for the purchase of obligations described in clause (ii) or (iii) of paragraph (3)(A).

The aggregate fair market value of the assets held in any such reserve shall not exceed 50 percent of the aggregate fair market value of all of the assets of the REMIC on the startup day, and the amount of any such reserve shall be promptly and appropriately reduced to the extent the amount held in such reserve is no longer reasonably required for purposes specified in clause (i) or (ii) of this subparagraph.

SECTIONS 860H-860L Repealed (together with other Code references to FASITs and FASIT regular interests).

REMIC REGULATIONS Replace the text of § 1.860E-1(c)(4) with the following:

(4) Safe harbor for establishing lack of improper knowledge. A transferor is presumed not to have improper knowledge if–

(i) The transferor conducted, at the time of the transfer, a reasonable investigation of the financial condition of the transferee and, as a result of the investigation, the transferor found that the transferee had historically paid its debts as they came due and found no significant evidence to indicate that the transferee will not continue to pay its debts as they come due in the future;

(ii) The transferee represents to the transferor that it understands that, as the holder of the noneconomic residual interest, the transferee may incur tax liabilities in excess of any cash flows generated by the interest and that the transferee intends to pay taxes associated with holding the residual interest as they become due;

(iii) The transferee represents that it will not cause income from the noneconomic residual interest to be attributable to a foreign permanent establishment or fixed base (within the meaning of an applicable income tax treaty) of the transferee or another U.S. taxpayer; and

(iv) The transfer satisfies either the asset test in paragraph (c)(5) of this section or the formula test in paragraph (c)(7) of this section.

(5) Asset test. The transfer satisfies the asset test if it meets the requirements of paragraphs (c)(5)(i), (ii) and (iii) of this section.

REMIC Regulations

193

(i) At the time of the transfer, and at the close of each of the transferee’s two fiscal years preceding the transferee’s fiscal year of transfer, the transferee’s gross assets for financial reporting purposes exceed $100 million and its net assets for financial reporting purposes exceed $10 million. For purposes of the preceding sentence, the gross assets and net assets of a transferee do not include any obligation of any related person (as defined in paragraph (c)(6)(ii) of this section) or any other asset if a principal purpose for holding or acquiring the other asset is to permit the transferee to satisfy the conditions of this paragraph (c)(5)(i).

(ii) The transferee must be an eligible corporation (defined in paragraph (c)(6)(i) of this section) and must agree in writing that any subsequent transfer of the interest will be to another eligible corporation in a transaction that satisfies paragraphs (c)(4)(i), (ii), and (iii) and this paragraph (c)(5). The direct or indirect transfer of the residual interest to a foreign permanent establishment (within the meaning of an applicable income tax treaty) of a domestic corporation is a transfer that is not a transfer to an eligible corporation. A transfer also fails to meet the requirements of this paragraph (c)(5)(ii) if the transferor knows, or has reason to know, that the transferee will not honor the restrictions on subsequent transfers of the residual interest.

(iii) A reasonable person would not conclude, based on the facts and circumstances known to the transferor on or before the date of the transfer, that the taxes associated with the residual interest will not be paid. The consideration given to the transferee to acquire the noneconomic residual interest in the REMIC is only one factor to be considered, but the transferor will be deemed to know that the transferee cannot or will not pay if the amount of consideration is so low compared to the liabilities assumed that a reasonable person would conclude that the taxes associated with holding the residual interest will not be paid. In determining whether the amount of consideration is too low, the specific terms of the formula test in paragraph (c)(7) of this section need not be used.

(6) Definitions for asset test. The following definitions apply for purposes of paragraph (c)(5) of this section:

(i) Eligible corporation means any domestic C corporation (as defined in section 1361(a)(2)) other than--

(A) A corporation which is exempt from, or is not subject to, tax under section 11;

(B) An entity described in section 851(a) or 856(a);

(C) A REMIC; or

(D) An organization to which part I of subchapter T of chapter 1 of subtitle A of the Internal Revenue Code applies.

(ii) Related person is any person that--

(A) Bears a relationship to the transferee enumerated in section 267(b) or 707(b)(1), using “20 percent” instead of “50 percent” where it appears under the provisions; or

(B) Is under common control (within the meaning of section 52(a) and (b)) with the transferee.

REMIC Regulations

194

(7) Formula test. The transfer satisfies the formula test if the present value of the anticipated tax liabilities associated with holding the residual interest does not exceed the sum of--

(i) The present value of any consideration given to the transferee to acquire the interest;

(ii) The present value of the expected future distributions on the interest; and

(iii) The present value of the anticipated tax savings associated with holding the interest as the REMIC generates losses.

(8) Conditions and limitations on formula test. The following rules apply for purposes of the formula test in paragraph (c)(7) of this section.

(i) The transferee is assumed to pay tax at a rate equal to the highest rate of tax specified in section 11(b)(1). If the transferee has been subject to the alternative minimum tax under section 55 in the preceding two years and will compute its taxable income in the current taxable year using the alternative minimum tax rate, then the tax rate specified in section 55(b)(1)(B) may be used in lieu of the highest rate specified in section 11(b)(1).

(ii) The direct or indirect transfer of the residual interest to a foreign permanent establishment or fixed base (within the meaning of an applicable income tax treaty) of a domestic transferee is not eligible for the formula test.

(iii) Present values are computed using a discount rate equal to the Federal short-term rate prescribed by section 1274(d) for the month of the transfer and the compounding period used by the taxpayer.

(9) Examples. The following examples illustrate the rules of this section:

Example 1. Transfer to partnership. X transfers a noneconomic residual interest in a REMIC to Partnership P in a transaction that does not satisfy the formula test of paragraph (c)(7) of this section. Y and Z are the partners of P. Even if Y and Z are eligible corporations that satisfy the requirements of paragraph (c)(5)(i) of this section, the transfer fails to satisfy the asset test requirements found in paragraph (c)(5)(ii) of this section because P is a partnership rather than an eligible corporation within the meaning of (c)(6)(i) of this section.

Example 2. Transfer to a corporation without capacity to carry additional residual interests. During the first ten months of a year, Bank transfers five residual interests to Corporation U under circumstances meeting the requirements of the asset test in paragraph (c)(5) of this section. Bank is the major creditor of U and consequently has access to U’s financial records and has knowledge of U’s financial circumstances. During the last month of the year, Bank transfers three additional residual interests to U in a transaction that does not meet the formula test of paragraph (c)(7) of this section. At the time of this transfer, U’s financial records indicate it has retained the previously transferred residual interests. U’s financial circumstances, including the aggregate tax liabilities it has assumed with respect to REMIC residual interests, would cause a reasonable person to conclude that U will be unable to meet its tax liabilities when due. The transfers in the last month of the year fail to satisfy the investigation requirement in paragraph (c)(4)(i) of this section and the asset test requirement of paragraph (c)(5)(iii) of this section because Bank has reason to know that U will not be able to pay the tax due on those interests.

REMIC Regulations

195

Example 3. Transfer to a foreign permanent establishment of an eligible corporation. R transfers a noneconomic residual interest in a REMIC to the foreign permanent establishment of Corporation T. Solely because of paragraph (c)(8)(ii) of this section, the transfer does not satisfy the formula test of paragraph (c)(7) of this section. In addition, even if T is an eligible corporation, the transfer does not satisfy the asset test because the transfer fails the requirements of paragraph (c)(5)(ii) of this section.

(10) Effective dates. Paragraphs (c)(4) through (c)(9) of this section are applicable to transfers occurring on or after February 4, 2000, except for paragraphs (c)(4)(iii) and (c)(8)(iii) of this section, which are applicable for transfers occurring on or after August 19, 2002. For the dates of applicability of paragraphs (a) through (c)(3) and (d) of this section, see §1.860A-1.

Add regulation § 1.860G-3(b) (which, according to § 1.860A-1(b)(5), applies to REMIC net income (including excess inclusions) of a foreign person with respect to a REMIC residual interest if the first net income allocation under section 860C(a)(1) to the foreign person with respect to that interest occurs on or after August 1, 2006):

(b) Accounting for REMIC net income -- (1) Allocation of partnership income to a foreign partner. A domestic partnership shall separately state its allocable share of REMIC taxable income or net loss in accordance with § 1.702-1(a)(8). If a domestic partnership allocates all or some portion of its allocable share of REMIC taxable income to a partner that is a foreign person, the amount allocated to the foreign partner shall be taken into account by the foreign partner for purposes of sections 871(a), 881, 1441, and 1442 as if that amount were received on the last day of the partnership’s taxable year, except to the extent that some or all of the amount is required to be taken into account by the foreign partner at an earlier time under section 860G(b) as a result of a distribution by the partnership to the foreign partner or a disposition of the foreign partner’s indirect interest in the REMIC residual interest. A disposition in whole or in part of the foreign partner’s indirect interest in the REMIC residual interest may occur as a result of a termination of the REMIC, a disposition of the partnership’s residual interest in the REMIC, a disposition of the foreign partner’s interest in the partnership, or any other reduction in the foreign partner’s allocable share of the portion of the REMIC net income or deduction allocated to the partnership. See § 1.871-14(d)(2) for the treatment of interest received on a regular or residual interest in a REMIC. For a partnership’s withholding obligations with respect to excess inclusion amounts described in this paragraph (b)(1), see § 1.1441-2(b)(5), § 1.1441-2(d)(4), § 1.1441-5(b)(2)(i)(A) and §§ 1.1446-1 through 1.1446-7.

(2) Excess inclusion income allocated by certain pass-through entities to a foreign person. If an amount is allocated under section 860E(d)(1) to a foreign person that is a shareholder of a real estate investment trust or a regulated investment company, a participant in a common trust fund, or a patron of an organization to which part I of subchapter T applies and if the amount so allocated is governed by section 860E(d)(2) (treating it “as an excess inclusion with respect to a residual interest held by” the taxpayer), the amount shall be taken into account for purposes of sections 871(a), 881, 1441, and 1442 at the same time as the time prescribed for other income of the shareholder, participant, or patron from the trust, company, fund, or organization.

196

Attachment

NYSBA REFORMS REPORT/SUMMARY OF RECOMMENDATIONS

III. Summary of Recommendations

This Part III summarizes our recommendations, which are then discussed in detail in later sections. The recommendations fall into four groups: those that can be viewed as an alternative to FASITs (including a change in the REMIC regulations to allow REMICs greater flexibility in servicing loans); other proposed changes in the REMIC regulations; changes in the regulations defining a TMP; and a fourth set of proposed changes not relating to FASITs, REMICs or TMPs. In our view, if the first set of recommendations were implemented, the goals of the FASIT legislation would be adequately addressed, and the FASIT rules could be, and should be, repealed. The changes in REMIC rules are mostly intended to accommodate changes in practices since the REMIC regulations were issued in 1992, including in particular the greater use of REMICs to securitize large commercial loans. The general goal of the TMP changes is to better tailor the definition of a TMP to cases in which taxpayers have a REMIC alternative. The last topic relates to information reporting by U.S. persons holding interests in a fixed investment trust that is a foreign trust for tax purposes.

A. FASIT-Related Changes

1. Clarify that a securitization vehicle classified as a partnership can pass through income on interest-bearing receivables to foreign portfolio investors holding partnership equity interests without a withholding tax. The recommendation has three parts. First, clarify the regulations defining a registration-required obligation for TEFRA registration purposes so that a pass-through certificate representing an interest in a pool of receivables would be a registration-required obligation even if the issuer were classified as a partnership. The change would ensure that the TEFRA registration requirements that must be met for the portfolio interest exception to apply are satisfied if the certificate meets those requirements even if the underlying receivables do not. (This rule would be helpful not only in revolving pool structures but also in fixed pool securitizations that are treated as partnerships under the Sears regulations.) Second, clarify that if a securitization partnership receives interest income and allocates it to a foreign partner, that income will not fail to qualify for an exemption from withholding tax because it is paid out in the form of a guaranteed payment. Finally, clarify that foreign portfolio investors holding equity in a securitization vehicle T that receives interest income on a loan to company X will not lose the benefit of the portfolio interest exemption because of equity interests in X held by other persons holding equity in T under a rule that attributes to partnerships (but not to other partners) property owned by a partner.

2. Clarify that income from an interest rate swap or other notional principal contract entered into by a securitization vehicle will have a source outside of the United States if the income is allocated to a foreign investor even if the securitization vehicle is classified as a partnership, provided the securitization vehicle is not engaged in a U.S. trade or business.

3 Issue a revenue ruling clarifying that a typical credit card trust will not be considered to be engaged in a financial business within the meaning of section 7704(d)(2) so that interest received on credit card receivables is regarded as qualifying income for purposes of the section 7704 passive income test.

REMIC Regulations

197

4. Issue a revenue ruling clarifying that a foreign person owning an equity interest in a credit card trust classified as a partnership will not be considered to be engaged in a trade or business within the United States within the meaning of section 864 by virtue of the activities of the trust. The ruling would be based on all facts and circumstances and on the securities trading safe-harbor rule in section 864(b)(2).

5. Issue a revenue ruling confirming that a class of beneficial interests issued by a credit card trust will be classified as debt if the interests have the economic and legal characteristics of debt (aside from the label) and the governing agreements require the issuer and holders to treat the class as debt for tax purposes. Again, the ruling would be based on all facts and circumstances set forth in the ruling.

6. Adopt a regulation under section 860G providing that a qualified mortgage held by a REMIC will not cease to be a qualified mortgage because the mortgage is modified, provided that the modification does not extend the term of the mortgage or increase its outstanding principal balance.

7. Adopt a parallel change in Treasury Regulation § 301.7701-4(c) that would permit an investment trust to have the power to consent to the same types of modifications to a real property mortgage without violating the power-to-vary test.

B. Other Changes in REMIC Regulations

8. Clarify the REMIC regulation relating to releases of real property collateral for a qualified mortgage to provide that a release will cause a loan to cease to be a qualified mortgage only if following the release the loan is no longer principally secured by an interest in real property.

9. Clarify the REMIC regulation defining a qualified mortgage to allow construction loans to be qualified mortgages.

10. Reduce the need to create multiple-tier REMIC structures by changing the definition of specified portion.

11. Clarify the funds-available cap rule to allow caps on specified portion classes. This change would reduce the need to create interest rate swaps or caps outside of a REMIC to accommodate basis risk.

12. Clarify the improper knowledge test that limits when property acquired on foreclosure of a mortgage can be “foreclosure property.”

13. Clarify that a REMIC can hold a qualified mortgage that is integrated with a hedge and treated as a single indebtedness for general tax purposes.

14. Clarify that income earned on funds held pending the purchase of qualified mortgages within the 3-month period ending on the startup day is not subject to the 100 percent prohibited transactions tax.

C. Changes Relating to TMPs

15. Change the TMP regulations to narrow or clarify the definition of a TMP in four ways: provide that an asset is a real estate mortgage for purposes of the TMP Asset Test (described in Part II.C.3, above) only if it is a qualified mortgage that can be held by a REMIC (subject to an anti-abuse

REMIC Regulations

198

exception); clarify that debt backed by revolving pools of loans does not meet the TMP Relationship Test; clarify that an entity does not meet the TMP Maturities Test if all debt of the entity is short term; and clarify that debt does not meet the Relationship Test if it provides for payments according to a fixed schedule.

D. Other Changes

16. Provide that new information reporting rules for widely held fixed investment trusts (“WHFITs”) supersede reporting under section 6048 by U.S. persons holding interests in foreign trusts where the WHFIT reporting rules apply. Require a foreign trust to be subject to the WHFIT rules if it has as a trustee a domestic bank or U.S. government-owned or -sponsored agency, and allow a foreign trust to elect to be subject to those rules if it designates such a bank or agency as a person responsible for information reporting. Limit the scope of reporting under section 6048 for holders of interests in foreign investment trusts that are not U.S. controlled to better conform the reporting for such trusts and for foreign partnerships.

FEDERAL INCOME TAXATION OF SECURITIZATION TRANSACTIONStaxsec.homestead.com/files/2008_Supplement.pdf · FEDERAL INCOME TAXATION OF SECURITIZATION TRANSACTIONS Third Edition, Frank

Documents