Interest Income & Expense
The Internal Revenue Code contains a number of tax provisions that hinge on whether a debt instrument is in registered form (see, e.g., Secs. 149, 163, 165, 1287, and 4701). The requirement that certain debt obligations be "in registered form" is intended to create a record of ownership and to discourage the use of bearer instruments (i.e., obligations not in registered form) as a potential means of avoiding taxes.
Registration Requirements
Usually, these registration requirements are easily met for standard instruments trading in the capital market; by contrast, most consumer loans (including mortgage loans), which generally do not require registration, typically are not issued in registered form. Therefore, for investments in mortgage loans, U.S.-source interest paid to a foreign investor on those mortgage loans may not qualify for the portfolio interest exemption in Secs. 871(h)(1) and 881(c)(1), which apply only to debt in registered form.
Fortunately, at least in the context of mortgage loans, Temp. Regs. Sec. 1.163-5T(d)(1) seeks to resolve this problem by providing that evidence of an interest in a pool of mortgage loans that is treated as a grantor trust "or similar evidence of interest in a similar pooled fund or pooled trust treated as a grantor trust" (i.e., a "pass-through certificate") is considered to be in registered form if the passthrough certificate is in registered form "without regard to whether any obligation held by the fund or trust to which the pass-through certificate relates" is in registered form.
Although it is not expressly referred to in Sec. 871 or 881 or the related regulations, practitioners and the IRS routinely look to the Sec. 163 definition of a passthrough certificate to apply the portfolio interest exemption to interest paid on pools of mortgage loans (seeRegs. Sec. 1.871-14(d)(1), providing that interest received on a passthrough certificate qualifies as portfolio interest if the interest satisfies the conditions in Regs. Sec. 1.871-14(c)(1), which are identical to the registration requirements described in Regs. Sec. 5f.103-1, without regard to whether any obligation held by the fund or trust to which the passthrough certificate relates is described in Regs. Sec. 1.871-14(c)(1)(ii)).
Due to the ambiguous definition of a passthrough certificate in Temp. Regs. Sec. 1.163-5T(d)(1), however, it is not clear what types of arrangements can qualify as passthrough certificates—i.e., it is not obvious what types of arrangements qualify as a "similar evidence of interest in a similar pooled fund or pooled trust treated as a grantor trust." A literal reading of the regulation would appear to indicate that it does not apply to equity interests issued by a trust that fails to be a grantor trust (e.g., because the trust has the power to vary its assets) or loses its grantor trust status (e.g., because of the trust's activities). As a result, investors and tax advisers have questioned whether application of Temp. Regs. Sec. 1.163-5T(d)(1) is limited solely to passthrough certificates issued by grantor trusts.
Letter Ruling 201504004
The IRS recently addressed this question in Letter Ruling 201504004. The letter ruling concluded that equity interests issued by nongrantor trust entities (a limited partnership master fund and a nongrantor trust) in an arrangement in which the underlying obligations (commercial mortgage loans) were not in registered form were each similar to passthrough certificates and therefore also may be considered obligations in registered form if the Regs. Sec. 5f.103-1(c)(1) requirements are satisfied.
This conclusion goes beyond prior IRS administrative guidance on the issue and, if followed for other taxpayers, would be a welcome clarification that the definition of a passthrough certificate in Temp. Regs. Sec. 1.163-5T(d)(1) is not limited solely to equity interests issued by grantor trusts. The letter ruling, however, may not be sufficient authority to provide tax advisers the support needed to rely on the IRS's view in the letter ruling when advising clients and instead may lead to an increase in the number of ruling requests submitted to the IRS on these issues.
Letter Ruling 201504004 involved a proposed transaction in which the taxpayer (Taxpayer) sought to treat interests in a partnership and a trust each as similar evidences of interest in a similar pooled fund or pooled trust under Temp. Regs. Sec. 1.163-5T(d)(1).
Taxpayer, a U.S. corporation and ultimate general partner in a number of related private investment funds, intends to implement a transaction in which (in relevant part) a foreign entity treated as a corporation for U.S. tax purposes will raise funds from foreign persons and use the funds to purchase interests in a U.S. limited partnership (Master Fund). Master Fund in turn will use these funds to acquire beneficial interests in certain low-credit-quality commercial mortgage loans (the Loans), which Taxpayer represented are "secured by mortgages [that] are not in registered form within the meaning of [Regs. Sec.] 5f.103-1(c)."
Master Fund then will contribute its interests in the Loans to a U.S. statutory trust treated as a disregarded entity for U.S. tax purposes (Trust) in exchange for ownership interests in Trust. Trust will engage independent servicers to service the Loans, which will include negotiating modifications to certain Loans, and will have the ability to vary its investments (thus failing to be a grantor trust). Interests in Master Fund and Trust will be transferable only pursuant to procedures described in Regs. Sec. 5f.103-1(c)(1). Neither Master Fund nor Trust will be treated as a grantor trust within the meaning of Regs. Sec. 301.7701-4(c)(1).
Taxpayer requested a ruling that the interests in Master Fund and Trust will be considered to be in registered form if the interests in those entities are transferable according to the procedures in Regs. Sec. 5f.103-1(c)(1). Based on these facts, the IRS concluded that the interests in Trust and Master Fund each qualified as "similar evidences of interest in a similar pooled fund within the meaning of [Temp. Regs. Sec.] 1.163-5T(d)(1), and that if the requirements of [Regs. Sec.] 5f.103-1(c)(1) are satisfied, the interests in Trust and Master Fund will be considered obligations in registered form."
The IRS, in reaching its conclusion, reiterated that "[t]he purpose of the registration requirement for certain obligations is to prevent the underreporting of tax on gains on sales on both taxable and tax-exempt securities and to ensure that securities will be sold (or resold in connection with the original issue) only to persons who are not United States persons." Accordingly, given the passthrough nature of the entities at issue and the proposed procedures Taxpayer intends to implement to track the interests sold to non-U.S. persons, the conclusion reached in Letter Ruling 201504004 may reflect IRS acknowledgment of the regulation's inherent ambiguity and indicate IRS thinking as to the types of equity interests, other than interests in grantor trusts, that may be eligible to be treated as passthrough certificates.
By allowing equity interests issued in an arrangement other than a grantor trust arrangement to be considered in registered form in certain circumstances, the IRS may be seeking to resolve some of the ambiguity in the definition of a passthrough certificate. Many questions remain, including how broadly the IRS may apply the conclusion in the letter ruling; for issuers and foreign investors, whether the IRS's reasoning in reaching its conclusion may apply for purposes of satisfying the portfolio interest exemption; and, in general, whether the Sec. 163 definition of a passthrough certificate controls for purposes of the portfolio interest exemption and to what extent workout activities for mortgage loans may be permissible in these contexts.
EditorNotes
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these
items, contact Ms. Smith at 202-414-1048
202-414-1048
or annette.smith@us.pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
