[Federal Register Volume 67, Number 139 (Friday, July 19, 2002)]
[Rules and Regulations]
[Pages 47451-47454]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-18021]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9004]
RIN 1545-AW98


Real Estate Mortgage Investment Conduits

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations relating to safe 
harbor transfers of noneconomic residual interests in real estate 
mortgage investment conduits (REMICs). The final regulations provide 
additional limitations on the circumstances under which transferors may 
claim safe harbor treatment.

DATES: Effective Date: These regulations are effective July 19, 2002.
    Applicability Date: For dates of applicability, see Sec. 1.860E-
(1)(c)(10).

FOR FURTHER INFORMATION CONTACT: Courtney Shepardson at (202) 622-3940 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information in this final rule has been reviewed 
and, pending receipt and evaluation of public comments, approved by the 
Office of Management and Budget (OMB) under 44 U.S.C. 3507 and assigned 
control number 1545-1675.
    The collection of information in this regulation is in Sec. 1.860E-
1(c)(5)(ii). This information is required to enable the IRS to verify 
that a taxpayer is complying with the conditions of this regulation. 
The collection of information is mandatory and is required. Otherwise, 
the taxpayer will not receive the benefit of safe harbor treatment as 
provided in the regulation. The likely respondents are businesses and 
other for-profit institutions.
    Comments on the collection of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of the Treasury, Office of Information and Regulatory Affairs, 
Washington, DC, 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S, Washington, DC 
20224. Comments on the collection of information should be received by 
September 17, 2002. Comments are specifically requested concerning:
    Whether the collection of information is necessary for the proper 
performance of the functions of the Internal Revenue Service, including 
whether the information will have practical utility;
    The accuracy of the estimated burden associated with the collection 
of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the collection of information may 
be minimized, including through the application of automated collection 
techniques or other forms of information technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    The estimated total annual reporting burden is 470 hours, based on 
an estimated number of respondents of 470 and an estimated average 
annual burden hours per respondent of one hour.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains final regulations regarding the proposed 
amendments to 26 CFR part 1 under section 860E of the Internal Revenue 
Code (Code). The regulations provide the circumstances under which a 
transferor of a noneconomic REMIC residual interest meeting the 
investigation and representation requirements may avail itself of the 
safe harbor by satisfying either the formula test or the asset test.
    Final regulations governing REMICs, issued in 1992, contain rules 
governing the transfer of noneconomic REMIC residual interests. In 
general, a transfer of a noneconomic residual interest is disregarded 
for all tax purposes if a significant purpose of the transfer is to

[[Page 47452]]

enable the transferor to impede the assessment or collection of tax. A 
purpose to impede the assessment or collection of tax (a wrongful 
purpose) exists if the transferor, at the time of the transfer, either 
knew or should have known that the transferee would be unwilling or 
unable to pay taxes due on its share of the REMIC's taxable income.
    Under a safe harbor, the transferor of a REMIC noneconomic residual 
interest is presumed not to have a wrongful purpose if two requirements 
are satisfied: (1) the transferor conducts a reasonable investigation 
of the transferee's financial condition (the investigation 
requirement); and (2) the transferor secures a representation from the 
transferee to the effect that the transferee understands the tax 
obligations associated with holding a residual interest and intends to 
pay those taxes (the representation requirement).
    The IRS and Treasury have been concerned that some transferors of 
noneconomic residual interests claim they satisfy the safe harbor even 
in situations where the economics of the transfer clearly indicate the 
transferee is unwilling or unable to pay the tax associated with 
holding the interest. For this reason, on February 7, 2000, the IRS 
published in the Federal Register (65 FR 5807) a notice of proposed 
rulemaking (REG-100276-97; REG-122450-98) designed to clarify the safe 
harbor by adding the ``formula test,'' an economic test. The proposed 
regulation provides that the safe harbor is unavailable unless the 
present value of the anticipated tax liabilities associated with 
holding the residual interest does not exceed the sum of: (1) The 
present value of any consideration given to the transferee to acquire 
the interest; (2) the present value of the expected future 
distributions on the interest; and (3) the present value of the 
anticipated tax savings associated with holding the interest as the 
REMIC generates losses.
    The notice of proposed rulemaking also contained rules for FASITs. 
Section 1.860H-6(g) of the proposed regulations provides requirements 
for transfers of FASIT ownership interests and adopts a safe harbor by 
reference to the safe harbor provisions of the REMIC regulations.
    In January 2001, the IRS published Rev. Proc. 2001-12 (2001-3 
I.R.B. 335) to set forth an alternative safe harbor that taxpayers 
could use while the IRS and the Treasury considered comments on the 
proposed regulations. Under the alternative safe harbor, if a 
transferor meets the investigation requirement and the representation 
requirement but the transfer fails to meet the formula test, the 
transferor may invoke the safe harbor if the transferee meets a two-
prong test (the asset test). A transferee generally meets the first 
prong of this test if, at the time of the transfer, and in each of the 
two years preceding the year of transfer, the transferee's gross assets 
exceed $100 million and its net assets exceed $10 million. A transferee 
generally meets the second prong of this test if it is a domestic, 
taxable corporation and agrees in writing not to transfer the interest 
to any person other than another domestic, taxable corporation that 
also satisfies the requirements of the asset test. A transferor cannot 
rely on the asset test if the transferor knows, or has reason to know, 
that the transferee will not comply with its written agreement to limit 
the restrictions on subsequent transfers of the residual interest.
    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 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.
    The Treasury and the IRS have learned that certain taxpayers 
transferring noneconomic residual interests to foreign branches have 
attempted to rely on the formula test to obtain safe harbor treatment 
in an effort to impede the assessment or collection of U.S. tax on 
excess inclusion income. Accordingly, the final regulations provide 
that if a noneconomic residual interest is transferred to a foreign 
permanent establishment or fixed base of a U.S. taxpayer, the transfer 
is not eligible for safe harbor treatment under either the asset test 
or the formula test. The final regulations also require a transferee to 
represent that it will not cause income from the noneconomic residual 
interest to be attributable to a foreign permanent establishment or 
fixed base.
    Section 1.860E-1(c)(8) provides computational rules that a taxpayer 
may use to qualify for safe harbor status under the formula test. 
Section 1.860E-1(c)(8)(i) provides that the transferee is presumed to 
pay tax at a rate equal to the highest rate of tax specified in section 
11(b). Some commentators were concerned that this presumed rate of 
taxation was too high because it does not take into consideration 
taxpayers subject to the alternative minimum tax rate. In light of the 
comments received, this provision has been amended in the final 
regulations to allow certain transferees that compute their taxable 
income using the alternative minimum tax rate to use the alternative 
minimum tax rate applicable to corporations.
    Additionally, Sec. 1.860E-1(c)(8)(iii) provides that the present 
values in the formula test are to be computed using a discount rate 
equal to the applicable Federal short-term rate prescribed by section 
1274(d). This is a change from the proposed regulation and Rev. Proc. 
2001-12. In those publications the provision stated that ``present 
values are computed using a discount rate equal to the applicable 
Federal rate prescribed in section 1274(d) compounded semiannually'' 
and that ``[a] lower discount rate may be used if the transferee can 
demonstrate that it regularly borrows, in the course of its trade or 
business, substantial funds at such lower rate from an unrelated third 
party.'' The IRS and the Treasury Department have learned that, based 
on this provision, certain taxpayers have been attempting to use 
unrealistically low or zero interest rates to satisfy the formula test, 
frustrating the intent of the test. Furthermore, the Treasury 
Department and the IRS believe that a rule allowing for a rate other 
than a rate based on an objective index would add unnecessary 
complexity to the safe harbor. As a result, the rule in the proposed 
regulations that permits a transferee to use a lower discount rate, if 
the transferee can demonstrate that it regularly borrows substantial 
funds at such lower rate, is not included in the final regulations; and 
the Federal short-term rate has been substituted for the applicable 
Federal rate. To simplify taxpayers' computations, the final 
regulations allow use of any of the published short-term rates, 
provided that the present values are computed with a corresponding 
period of compounding. With the exception of the provisions relating to 
transfers to foreign branches, these changes generally have the 
proposed applicability date of February 4, 2000, but taxpayers may 
choose to apply the interest rate formula set forth in the proposed 
regulation and Rev. Proc. 2001-12 for transfers occurring before August 
19, 2002.
    It is anticipated that when final regulations are adopted with 
respect to

[[Page 47453]]

FASITs, Sec. 1.860H-6(g) of the proposed regulations will be adopted in 
substantially its present form, with the result that the final 
regulations contained in this document will also govern transfers of 
FASIT ownership interests with substantially the same applicability 
date as is contained in this document.

Effect on Other Documents

    Rev. Proc. 2001-12 (2001-3 I.R.B. 335) is obsolete for transfers of 
noneconomic residual interests in REMICs occurring on or after August 
19, 2002.

Special Analyses

    It is hereby certified that these regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the fact that it is unlikely that a 
substantial number of small entities will hold REMIC residual 
interests. Therefore, a Regulatory Flexibility Analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. It has 
been determined that this Treasury decision is not a significant 
regulatory action as defined in Executive Order 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
sections 553(b) and 553(d) of the Administrative Procedure Act (5 
U.S.C. chapter 5) do not apply to these regulations.

Drafting Information

    The principal author of these regulations is Courtney Shepardson. 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and record keeping requirements.

26 CFR Part 602

    Reporting and record keeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *


    Par. 2. In Sec. 1.860A-0, entries in the outline for Sec. 1.860E-
1(c)(5) through (c)(10) are added to read as follows:


Sec. 1.860A-0  Outline of REMIC provisions.

* * * * *


Sec. 1.860E-1  Treatment of taxable income of a residual interest 
holder in excess of daily accruals.

* * * * *
    (c) * * *
    (5) Asset test.
    (6) Definitions for asset test.
    (7) Formula test.
    (8) Conditions and limitations on formula test.
    (9) Examples.
    (10) Effective dates.
* * * * *


    Par. 3. Section 1.860E-1 is amended as follows:
    1. Paragraph (c)(4)(i) is amended by removing the language ``and'' 
at the end of the paragraph.
    2. Paragraph (c)(4)(ii) is amended by removing the period at the 
end of the paragraph and adding a semicolon in its place.
    3. Paragraphs (c)(4)(iii) and (c)(4)(iv) are added.
    4. Paragraphs (c)(5) through (c)(10) are added.
    The additions read as follows:


Sec. 1.860E-1  Treatment of taxable income of a residual interest 
holder in excess of daily accruals.

* * * * *
    (c) * * *
    (4) * * *
    (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.
    (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.
    (7) Formula test. The transfer satisfies the formula test if the 
present value of the anticipated tax liabilities associated

[[Page 47454]]

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.
    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 Sec. 1.860A-1.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 4. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


    Par. 5. In Sec. 602.101, paragraph (b) is amended by adding an 
entry in numerical order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
         *        *        *        *        *        *        *
1.860E-1................................................       1545-1675
 
         *        *        *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: July 10, 2002
Pamela F. Olson,
Acting Assistant Secretary of the Treasury.
[FR Doc. 02-18021 Filed 7-18-02; 8:45 am]
BILLING CODE 4830-01-P