June 20, 2000

The Honorable Charles O. Rossotti
Commissioner
Internal Revenue Service, Room 3000 IR
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Jonathan Talisman, Esq.
Acting Assistant Secretary (Tax Policy)
Treasury Department, Room 1330 MT
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Re: Proposed Regulations and Legislation To Prevent Evasion of Tax on
REMIC Residual Interests

Dear Commissioner Rossotti and Mr. Talisman:
[1] I am pleased to enclose a report of the New York State Barÿ
Association Tax Section¹commenting on two recent proposals intended toÿ
prevent evasion of tax on residual interests in Real Estate Mortgageÿ
Investment Conduits ("REMICs") and ownership interests in Financial Assetÿ
Securitization Investment Trusts ("FASITs").

[2] One of the two proposals is legislative. The Administration'sÿ
Fiscal Year 2001 Budget proposed that REMICs be made secondarily liableÿ
for tax owed by holders of their residual interests. Similarly, FASITsÿ
would be made secondarily liable for tax owed by holders of theirÿ
ownership interests.

[3] The other proposal addressed in our report is regulatory. Earlyÿ
this year, regulations were proposed that could effectively imposeÿ
secondary liability on transferors of REMIC residual interests (and FASITÿ
ownership interests) for tax owed by the transferee unless the amount paidÿ
as consideration to the transferee at least equals the present value ofÿ
the tax, computed using certain assumptions that often are unrealistic.ÿ
Failure to pay this amount would prevent transferors from relying on aÿ
"safe harbor" in current regulations, and thus subject them to the riskÿ
that a transfer will be disregarded for tax purposes.

[4] Although we agree with the Treasury Department that changes inÿ
current law are needed to reduce opportunities for evasion of tax onÿ
income from residual interests, we believe that these proposals couldÿ
seriously and unnecessarily impede use of REMICs (and FASITs). In ourÿ
report, we propose other changes in the law that would, we believe,ÿ
adequately address any opportunities for tax evasion without imposingÿ
unnecessary costs on securitization transactions.

[5] Because any tax owed by a REMIC (or FASIT) under the legislativeÿ
proposal generally would be paid from assets needed to make payments dueÿ
holders of regular interests, the proposal effectively imposes contingentÿ
liability on regular interests for tax owed by residual interest holders.ÿ
Imposing contingent liability on regular interests could make it difficultÿ
(or impossible) for such interests to be rated by rating agencies orÿ
traded in the market. Congress enacted the REMIC rules in part to increaseÿ
the efficiency and liquidity of the mortgage market. By increasing theÿ
costs of using REMICs and reducing liquidity in their regular interests,ÿ
the legislative proposal will undermine that purpose.

[6] Although its consequences may be less serious, the proposedÿ
amendment to current regulations would also impede use of REMICs (andÿ
FASITs). The proposed amendment would have this effect because it wouldÿ
make transfers of residuals more difficult and expensive. REMIC sponsorsÿ
often are not the most efficient holders of residuals; in fact, someÿ
sponsors may be precluded by law from holding residuals because they areÿ
"disqualified organizations".

[7] As alternatives to these two proposals, the enclosed reportÿ
suggests several changes to current law to minimize opportunities forÿ
avoidance of tax on income from REMIC residual interests (and FASITÿ
ownership interests). First, we propose expansion of the list ofÿ
"disqualified organizations" (which effectively cannot hold residuals) toÿ
include Indian tribes and tribal corporations. Second, we propose thatÿ
issuance or transfer of an interest in a partnership or other pass-throughÿ
entity holding REMIC residual interests be treated as a transfer of thoseÿ
interests, and thus as subject to the same restrictions that current lawÿ
imposes on direct transfers. Finally, we propose that the safe harbor inÿ
current regulations (which gives transferors certainty that transfers willÿ
not be disregarded) be converted into a substantive rule; thus, if itsÿ
requirements are not met, the transferor would be secondarily liable forÿ
tax owed by the transferee. We also describe several other ways thatÿ
transfers of residuals might be restricted to address concerns aboutÿ
abuse. Some of the changes described in our report would requireÿ
legislation, while others could be made by regulation.

[8] Please let me know if we can be of further assistance inÿ
consideration of the issues addressed in the enclosed report.

Sincerely,
Robert H. Scarborough
cc: Treasury Department

Eric Solomon, Esq.
Acting Deputy Assistant Secretary (Tax Policy)

Joseph M. Mikrut, Esq.
Tax Legislative Counsel

Michael S. Novey, Esq.
Attorney-Advisor

INTERNAL REVENUE SERVICE
The Honorable Stuart L. Brown
Chief Counsel

Lon B. Smith, Esq.
Assistant Chief Counsel

Marshall D. Feiring, Esq.
Senior Technician Reviewer
CC: DOM:CORP: R (REG 100276-97 and REG 122450-98)

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ÿNEW YORK STATE BAR ASSOCIATION
TAX SECTION
REPORT ON PROPOSALS
REGARDING TRANSFERS OF
REMIC AND FASIT RESIDUAL INTERESTS

I. INTRODUCTION.

[9] This report² comments on a proposal in the Administration'sÿ
Fiscal Year 2001 Budget to impose secondary liability on real estateÿ
mortgage investment conduits ("REMICs") and financial asset securitizationÿ
investment trusts ("FASITs") for tax owed by holders of residualÿ
interests. This report also comments on the proposed amendment toÿ
regulations section 1.860E-1(c)(4) denying that provision's safe harbor toÿ
transferors of noneconomic REMIC and FASIT residual interests unless theÿ
consideration paid for the transfer and the residual's expected cash flowsÿ
together exceed the holder's net expected tax liabilities (all determinedÿ
on a present value basis and assuming the highest marginal corporateÿ
rate).³

[10] We share the Treasury Department's concern that taxpayers may beÿ
attempting to avoid tax on income allocable to holders of residualÿ
interests, and we agree that current rules should be tightened to preventÿ
potential abuse. However, we do not believe that secondary liability forÿ
the residual holder's tax should be imposed on a REMIC. ⁴ Because taxÿ
owed by a REMIC would be paid out of assets required to pay interest andÿ
principal due regular interest holders, the burden of any tax imposedÿ
under the proposal would fall on regular interest holders. Thus, theÿ
practical effect of the proposal is to make holders of regular interestsÿ
secondarily liable for tax on income allocable to residual interestÿ
holders.

[11] We object to burdening regular interest holders with tax thatÿ
residual holders fail to pay for the following reasons. First, aÿ
contingent liability on regular interests would introduce uncertainty intoÿ
their pricing and adversely affect their liquidity. It would thereby tendÿ
to frustrate the primary purpose of the REMIC rules, which was to increaseÿ
efficiency of capital markets. Second, because regular interest holders doÿ
not have contact with residual interest holders, effectively imposingÿ
contingent liability on regular interest holders is an inefficient meansÿ
of ensuring that residual interest holders pay tax. In this report, weÿ
propose alternative changes to the rules governing transfers of residualÿ
interests that would be more effective and efficient means of preventingÿ
tax evasion.

[12] Rules facilitating transfers of residual interests increase theÿ
economic efficiency of the REMIC vehicle and thus advance Congress'sÿ
objective in enacting the REMIC provisions. We recognize, of course, thatÿ
the goal of economic efficiency must be balanced against the need toÿ
prevent abusive transfers of residual interests that may permit taxÿ
evasion. Proposed regulations section 1.860E-1(c)(4) would, however, denyÿ
the safe harbor to certain nonabusive transfers of residuals and thusÿ
would unnecessarily reduce the economic efficiency of the REMIC vehicleÿ
and of the mortgage market. To prevent abusive transfers of residualsÿ
without unnecessarily reducing market liquidity, this report suggests thatÿ
the current safe harbor be converted into a substantive rule; thus, aÿ
transferor that does not satisfy its requirements would be secondarilyÿ
liable for tax on income allocable to the transferred interest. We alsoÿ
suggest additional safeguards to help assure that the residual interestÿ
holder pays tax it owes.

[13] In short, we recommend as follows:
1. American Indian tribes and tribal corporations should be added toÿ
the list of disqualified organizations.

2. The transfer of an interest in a partnership or other pass throughÿ
entity that holds a residual interest should be treated as a "transfer" ofÿ
the residual by the transferor, and the issuance of an interest in such anÿ
entity should be treated as a transfer of the residual interest by theÿ
pass through entity (i.e., an "aggregate approach" would be applied to theÿ
residual). Accordingly, the putative transfer would be disregarded withÿ
respect to the residual interest under existing rules if it was abusive.

3. Neither a REMIC nor its regular interest holders should be liableÿ
for the tax liability of the residual holder.

4. The safe harbor in proposed regulations section 1.860E- 1(c)(4)ÿ
should be converted into a substantive rule that imposes secondaryÿ
liability for the residual tax liability on a transferor that does notÿ
comply with it. We also suggest some possible additional restrictions.

II. BACKGROUND.
A. IN GENERAL.
[14] Congress enacted the REMIC provisions in 1986 to permitÿ
mortgages to be pooled and interests in them sold without imposition of aÿ
corporate-level tax, and to eliminate uncertainty regarding the taxÿ
treatment of those interests. Thus, under the REMIC rules, the REMICÿ
entity is not generally subject to tax, and regular interests issued byÿ
the REMIC are treated as indebtedness for federal income tax purposes andÿ
are subject to a stable and widely- understood tax regime. The REMICÿ
provisions have largely succeeded in advancing Congress's goal ofÿ
increasing the liquidity of mortgage loans and the efficiency of theÿ
mortgage markets. The FASIT provisions were enacted in 1997 to achieveÿ
similar objectives for a broader class of assets.

[15] In the REMIC provisions, Congress also sought to assure that taxÿ
would be paid on a specified amount of the "phantom income" of a REMICÿ
that arises when, in a "normal" interest rate environment (i.e., long-termÿ
interest rates exceed short-term rates), long-term mortgages are financedÿ
by issuance of different tranches of debt with varying maturities (as isÿ
generally the case with REMICs). Accordingly, under section 860C, theÿ
residual interest holder is subject to tax on the net income of the REMICÿ
and, in all events, is subject to tax on the REMIC's "excess inclusionÿ
income," which is intended to be a proxy for the REMIC's phantom income.ÿ
⁵ The REMIC provisions impose three separate mechanisms to ensure thatÿ
tax on excess inclusion income may not be avoided by transfers to personsÿ
that will not pay the tax. Each of these three mechanisms is discussedÿ
below.

B. PENALTY TAX ON TRANSFERS TO DISQUALIFIED ORGANIZATIONS.
[16] First, to qualify as a REMIC, an entity must have in placeÿ
"reasonable arrangements" to prevent ownership of residual interests byÿ
certain persons -- "disqualified organizations" -- that are not subject toÿ
U.S. federal income tax.⁶ Moreover, the transfer of a residual interestÿ
to a disqualified organization subjects the transferor to a penalty taxÿ
equal to the highest marginal corporate rate times the present value ofÿ
anticipated excess inclusions for periods after the transfer. ⁷ A tax atÿ
the highest marginal corporate rate is also imposed on the excessÿ
inclusion income of any "pass through entity" to the extent allocable toÿ
its disqualified organization interest holders.⁸

[17] Disqualified organizations include (i) the United States, itsÿ
states and political subdivisions, (ii) foreign governments andÿ
international organizations (and their agencies and instrumentalities),ÿ
(iii) tax-exempt organizations not subject to the tax on "unrelatedÿ
business taxable income," and (iv) cooperatives described in sectionÿ
1381(a)(2)(C).⁹ However, American Indian tribes and tribal corporationsÿ
are not included in this list.

[18] Under section 860E(e)(4) and its regulations, the transferor ofÿ
a residual interest is not subject to the section 860E(e) penalty tax ifÿ
the transferee furnishes to the transferor an affidavit containing theÿ
transferee's social security number and a statement, signed underÿ
penalties of perjury, that the transferee is not a disqualifiedÿ
organization.¹⁰

C. RESTRICTIONS ON TRANSFERS OF "NONECONOMIC RESIDUALS" TO
DOMESTIC ENTITIES.
[19] Second, under regulations, if a "noneconomic residual interest"ÿ
¹¹ is transferred to a domestic entity and a "significant purpose" ofÿ
the transfer is to impede the assessment or collection of tax, theÿ
transfer is disregarded and the transferor remains liable for the tax onÿ
the residual.¹² A significant purpose to impede the assessment orÿ
collection of tax is deemed to exist if the transferor knows or shouldÿ
have known (i.e., the transferor has "improper knowledge") that theÿ
transferee would be unwilling or unable to pay the taxes due on its shareÿ
of the REMIC's taxable income.¹³ On the other hand, under a safeÿ
harbor, the regulations presume that the transferor does not have improperÿ
knowledge if it (i) conducts a reasonable investigation of the financialÿ
condition of the transferee and, as a result of the investigation, findsÿ
that the transferee has historically paid its debts as they came due andÿ
there exists no significant evidence to indicate that the transferee willÿ
not continue to pay its debts as they come due in the future, and (ii)ÿ
receives a representation that the transferee understands that, as aÿ
holder of a noneconomic residual interest, it may incur tax liabilities inÿ
excess of cash flows generated by the interest and that the transfereeÿ
intends to pay the taxes as they come due.¹⁴

D. RESTRICTIONS ON TRANSFERS OF CERTAIN RESIDUALS TO FOREIGN
PERSONS.
[20] Finally, under rules that are analogous to the rules forÿ
noneconomic residual transfers to domestic transferees, the regulationsÿ
provide that the transfer of a residual interest with "tax avoidanceÿ
potential" to a foreign person that does not report the residual interestÿ
income as effectively connected with its U.S. trade or business also isÿ
disregarded and the transferor remains liable for the tax on the residual.ÿ
¹⁵ In general, a residual interest has tax avoidance potential if theÿ
cash flows of the residual interest are insufficient to satisfy a 30%ÿ
withholding tax on excess inclusion income.¹⁶ Under a safe harbor, aÿ
residual interest is not treated as having tax avoidance potential (andÿ
thus the transfer is not disregarded) if, based on each prepayment speedÿ
between 50% and 200% of the REMIC's assumed prepayment speed, the REMICÿ
would distribute enough cash to satisfy the 30% tax. ¹⁷ For a residualÿ
that is treated as not having tax avoidance potential, no representationÿ
from the transferee is needed to ensure that the transfer is notÿ
disregarded.

III. POTENTIAL ABUSES INVOLVING TRANSFERS OF RESIDUAL INTERESTS, AND
THE ADMINISTRATION'S PROPOSALS.
A. POTENTIAL ABUSES.
[21] As indicated above, one of Congress's objectives in enacting theÿ
REMIC provisions was to ensure that, in all events, tax is paid on aÿ
REMIC's excess inclusion income. The Treasury Department, the Jointÿ
Committee on Taxation and commentators have identified at least threeÿ
potential methods by which taxpayers may nevertheless attempt to avoidÿ
this liability.

[22] First, American Indian tribes and tribal corporations organizedÿ
under federal law are not subject to U.S. federal income tax, ¹⁸ butÿ
Congress neglected to include them in the list of disqualifiedÿ
organizations. One commentator has speculated that REMIC residuals areÿ
held by American Indian tribes, and that the associated excess inclusionÿ
income escapes tax.¹⁹

[23] Second, the restrictions on transfers of noneconomic interestsÿ
and residual interests with tax avoidance potential arguably do not applyÿ
to transfers of interests in partnerships or other pass through entitiesÿ
that own residuals, or to issuances of interests in these entities. Thus,ÿ
a U.S. taxpayer that owns a negative value residual in a domesticÿ
partnership could cause the partnership to issue interests to foreignÿ
persons, and claim that the issuance is not a "transfer" of the residualÿ
interest. In fact, the Internal Revenue Service ("IRS") is currentlyÿ
litigating such a case in Tax Court.²⁰

[24] Finally, a bankruptcy proceeding may excuse a residual holderÿ
from tax liability on the excess inclusion income. Thus, conceivably, aÿ
noneconomic residual interest could be purchased by a corporation thatÿ
subsequently declares bankruptcy, and the tax liability would beÿ
discharged. Unless the transferor "knew or should have known" that theÿ
corporate transferee would be unwilling or unable to pay tax on incomeÿ
from the residual, liability could not be imposed on the transferor.

B. THE ADMINISTRATION'S PROPOSALS.
[25] The Treasury Department and the IRS have become concerned thatÿ
taxpayers may be evading tax on income from residual interests. To addressÿ
potential abuses, in February 2000, the Treasury Department proposedÿ
regulatory and statutory amendments to prevent abusive residual interestÿ
transfers.

[26] First, as part of the FASIT proposed regulations package issuedÿ
on February 4, 2000, Treasury and the IRS proposed an additional conditionÿ
for the safe harbor under regulations section 1.860E-1(c)(4) for transfersÿ
of noneconomic REMIC residuals (and FASIT ownership interests). Under theÿ
proposed regulation, the safe harbor would be available only if theÿ
present value of the anticipated tax liabilities associated with holdingÿ
the residual interest (computed based on the highest marginal corporateÿ
tax rate)²¹ does not exceed the sum of (i) the present value of anyÿ
consideration paid to the transferee to acquire the interest, (ii) theÿ
present value of the expected future distributions on the interest, andÿ
(iii) the present value of the anticipated tax savings associated withÿ
holding the interest as the REMIC generates losses. The change is proposedÿ
to be effective for transfers on and after February 4, 2000.

[27] Second, as part of the Administration's Fiscal Year 2001 Budgetÿ
Revenue Proposals, the Treasury Department proposed to make REMICs andÿ
FASITs secondarily liable for tax owed by holders of residual interests.ÿ
Because tax owed by a REMIC or FASIT would be paid from assets otherwiseÿ
used to make payments due regular interest holders, the proposal wouldÿ
effectively impose secondary liability on holders of regular interests toÿ
the extent of their value. The provision is proposed to be effective forÿ
REMICs created after the date of enactment.

IV. COMMENTS ON THE PROPOSALS.
A. IN GENERAL.
[28] We share the concern of the Treasury Department and the IRS thatÿ
certain taxpayers may be attempting to avoid residual interest tax.ÿ
However, we believe that the proposal to impose secondary liability forÿ
the residual tax on REMICs and FASITs (and, in practical effect, on theirÿ
regular interest holders) would significantly impair the effectiveness ofÿ
these vehicles and thus frustrate Congress's purpose in creating them. Weÿ
also believe that it is not the best means of insuring that the tax is inÿ
fact paid.

[29] Effective securitization of assets requires that theÿ
securitization vehicle not be subject to the claims of third-partyÿ
creditors. The proposal to impose secondary liability on a REMIC or FASITÿ
for tax owed by its residual interest holder (or owner) would violate thisÿ
requirement. We understand that, if this proposal were enacted, theÿ
contingent tax liability on the REMIC or FASIT would adversely affect theÿ
credit rating of regular interests issued by "private label REMICs," ²²ÿ
and would preclude a "AAA" rating for any class of regular interestsÿ
without additional reserves to cover the contingent liability. Requiringÿ
REMICs to hold additional reserves would defeat the purpose of providingÿ
an economically efficient vehicle for securitizing mortgage loans. ²³

[30] Second, we do not believe that the proposal would help ensureÿ
that residual holders in fact pay their tax liability. Although regularÿ
interest holders would bear the economic burden of tax not paid by theÿ
residual interest holder, because regular interest holders rarely (and inÿ
public transactions never) have privity with the residual holder, theyÿ
would be unable to ensure that the residual holder actually pays its tax.ÿ
We believe that it is possible to address the problem of abusive transfersÿ
of residuals without affecting the liquidity of regular interests;ÿ
therefore we oppose imposition of secondary liability for the residualÿ
interest tax on the REMIC (and, by extension, on its regular interestÿ
holders).

[31] Proposed regulations section 1.860E-1(c)(4) presents moreÿ
difficult issues. Residual interest liquidity generally improves theÿ
economic efficiency of the REMIC vehicle (and, consequently, the mortgageÿ
market). The goal of increasing efficiency of the mortgage market must, ofÿ
course, be balanced against the need to prevent tax evasion. We suggest aÿ
number of alternatives to balance these competing policies.
B. ADDITION OF AMERICAN INDIAN TRIBES AND TRIBAL CORPORATIONS TO
THE LIST OF DISQUALIFIED ORGANIZATIONS.

[32] We are not aware of American Indian tribes or tribalÿ
corporations holding residual interests. Nevertheless, we recommend thatÿ
section 860E(e)(5) be amended to add American Indian tribes and tribalÿ
corporations organized under federal law to the list of disqualifiedÿ
organizations. The Treasury Department should also be granted regulatoryÿ
authority to add additional entities that are not subject to federalÿ
income tax.

C. TRANSFER OR ISSUANCE OF A PARTNERSHIP INTEREST TREATED AS A
TRANSFER OF ANY RESIDUAL HELD BY THE PARTNERSHIP.
[33] To prevent taxpayers from using partnerships, trusts and otherÿ
flow-through vehicles to avoid tax on negative value residuals, weÿ
recommend that the certification requirements of regulations sectionsÿ
1.860E-1(c) and 1.860G-3 be amended to provide that the transfer of aÿ
beneficial interest in a partnership, trust, estate, or other "passÿ
through" entity (as defined in section 860E(e)(6)(B)) that holds aÿ
residual interest is treated as a "transfer" of the residual by theÿ
transferor, and to provide that the issuance of an interest in such anÿ
entity is treated as a "transfer" of the residual interest by the passÿ
through entity. Accordingly, the putative transfer (with respect to theÿ
residual only, and not the entity's other assets) would be disregardedÿ
under existing rules if abusive.

[34] The existing certification safe harbors would apply to transfersÿ
of interests in flow-through entities. Moreover, a certification from theÿ
transferee of an interest in a pass through entity would not be necessaryÿ
if a representative of the pass through entity certifies (under penaltiesÿ
of perjury) in the year of the transfer that the entity's cash flows toÿ
the transferee from the residual and its other assets (less applicableÿ
withholding) are expected to be sufficient to pay the transferor's taxÿ
liability with respect to the residual in each year based on prepaymentÿ
speeds between 50% and 200% of the REMIC's assumed prepayment speed. ²⁴

[35] The amendment would not affect the ability of the IRS underÿ
current law to attack the use of a partnership or other entity to avoidÿ
residual tax liability under the existing anti-abuse rules and otherÿ
common law doctrines.

D. ALTERNATIVES TO PROPOSED REGULATIONS SECTION 1.860E-1(C)(4).
[36] For a variety of reasons, in certain cases it is eitherÿ
impossible, unfeasible, or otherwise economically inefficient for a REMICÿ
sponsor to retain a noneconomic residual interest. For example, becauseÿ
GNMA is a disqualified organization, it is not permitted to hold theÿ
residuals from the REMICs it sponsors. In addition, mortgage originationÿ
(and not cash flow management) is the core business of many REMICÿ
sponsors, and they generally do not have the professional personnel toÿ
manage the liability represented by a REMIC residual and to efficientlyÿ
invest the cash reserves necessary to fund the liability. Accordingly, asÿ
a matter of efficient balance sheet management, these sponsors prefer toÿ
transfer the residual (and the liability it represents) to a party that isÿ
better able to manage it.

[37] Rules that require REMIC sponsors to increase the amounts theyÿ
pay to transfer residuals (or, worse, that preclude them from transferringÿ
residuals), increase their cost of doing business. All or a portion ofÿ
this increased cost, in turn, is passed along through the market as anÿ
additional cost of mortgage lending and ultimately increases mortgageÿ
interest rates. In contrast, rules that minimize consideration REMICÿ
sponsors must pay to transfer noneconomic residuals generally minimizeÿ
their cost of doing business, which improves the efficiency of theÿ
mortgage market. We believe that enhancing efficiency of the mortgageÿ
market is an important policy goal and was a major purpose of the REMICÿ
regime.

[38] The proposed regulation would require that the consideration forÿ
the transfer plus the residual interest's future cash flow exceed the taxÿ
liability associated with the residual, based on the highest marginalÿ
corporate income tax rate and the present value of expected futureÿ
distributions, discounted at the applicable federal rate (or lower rateÿ
only if the transferee can demonstrate a lower borrowing rate). Thisÿ
proposed formula may overstate the consideration that a transferee wouldÿ
demand if the transferee is able to invest the payment at a rate thatÿ
exceeds the applicable federal rate. Moreover, market changes after theÿ
REMIC is organized may cause the expected prepayment rate to be higher atÿ
the time of the transfer of the residual than the REMIC's prepaymentÿ
assumption, thereby also justifying the payment of less consideration, andÿ
the proposed regulation is unclear as to whether the transferee may takeÿ
into account these market changes in determining the present value of theÿ
net tax liabilities associated with the residual. AMT taxpayers may beÿ
subject to a marginal rate of 20%, rather than 35%, on their excessÿ
inclusion income during some or all periods. Finally, taxpayers areÿ
permitted to offset tax on excess inclusions by certain credits, such asÿ
low-income housing tax credits, also resulting in an effective tax rateÿ
that is less than the highest marginal rate. Therefore, the proposedÿ
regulation is overbroad and denies safe harbor treatment for manyÿ
nonabusive transfers. Moreover, to the extent the proposed regulation doesÿ
not increase the likelihood that the residual tax will be paid, it isÿ
unsuited to the task of preventing abuse.
[39] Although the proposed regulation would affect only a "safeÿ
harbor," in practice, because the stakes are so high for the transferor ofÿ
a noneconomic residual interest (i.e., the transferor pays the transfereeÿ
to accept the residual and, if the transfer is disregarded, the transferorÿ
is out the payment and is subject to tax), the safe harbor has effectivelyÿ
become the substantive rule for major REMIC transactions and is regularlyÿ
incorporated into transaction documents. As a practical matter, therefore,ÿ
the proposed regulation would effectively preclude or impede nonabusiveÿ
transfers of residuals, and thus would make mortgage securitizations usingÿ
REMICs less efficient.

[40] Nevertheless, we recognize that the policy goal of economicÿ
efficiency must be balanced against the policy goal of preventing taxÿ
evasion through abusive residual transfers. To minimize opportunities forÿ
evasion, without unnecessarily impeding transfers of residuals, weÿ
recommend that the safe harbor of regulations section 1.860E-1(c)(4) beÿ
converted into a substantive rule, so that any transferor not complyingÿ
would be secondarily liable for tax on income from the transferredÿ
residual. In other words, if a transferor does not comply with theÿ
regulation's requirements to conduct an investigation of the financialÿ
condition of the transferee and receive a representation from theÿ
transferee as to its intent to pay the tax, and the transferee does not inÿ
fact pay the residual tax liability, the transferor would remain liableÿ
for the tax and would not be permitted to escape liability byÿ
demonstrating that it did not know and should not have known that theÿ
transferee would fail to pay the tax. (However, if the tax is in fact paidÿ
by the transferee, the transfer would be respected even if the transferorÿ
does not comply with the safe harbor.) We believe this change will helpÿ
prevent abusive residual transfers without adversely affecting residualÿ
liquidity. If this change is not sufficient to prevent residual abuse, weÿ
suggest below a number of alternatives to proposed regulations sectionÿ
1.860E-1(c)(4) that attempt to balance the goals of maximizing liquidityÿ
for noneconomic residuals and preventing abuse.

1. PENALTIES OF PERJURY STATEMENT BY CFO (OR EQUIVALENT OFFICER) OFÿ
THE TRANSFEREE. First, regulations sections 1.860E-1(c)(4) could beÿ
amended to impose the additional requirement that the transferor receive aÿ
certification from the chief financial officer (or equivalent officer) ofÿ
the transferee, signed under penalties of perjury, that the CFO hasÿ
personal knowledge of the financial condition of the transferee and, toÿ
the best of the CFO's knowledge, all tax liability with respect to theÿ
residual will in fact be paid (even if it exceeds the transferee'sÿ
projections). In the case of any transferee that is a pass through entity,ÿ
the certification would be received from the CFO (or equivalent officer)ÿ
of each beneficial owner.²⁵ The safe harbor would not be available ifÿ
the transferor knew or had reason to know that the certification wasÿ
false. In addition, transfers of residuals would be reported to the IRSÿ
along with the penalties of perjury statement.

[41] Requiring certification under penalties of perjury by anÿ
individual senior officer of the transferee would (i) place responsibilityÿ
where it belongs -- on an individual responsible for the transferee'sÿ
activities, (ii) permit maximum flexibility for nonabusive residualÿ
interest transfers,²⁶ and (iii) ensure residual liquidity and thereforeÿ
maximize economic efficiency. Of course, a penalties-of-perjury statementÿ
would not absolutely ensure payment of the residual tax. Even assuming theÿ
statement is made in good faith, abuses could occur after the signatoryÿ
resigns as an officer of the transferee. It is also possible, althoughÿ
less likely, that a transferee would hire a CFO solely to sign theÿ
statement.

2. MODIFIED PROPOSED REGULATION. Under a second approach, a modifiedÿ
version of the proposed regulation would be adopted permitting transfersÿ
for less consideration than generally required if the transferor couldÿ
justify the lesser amount by considerations such as (i) a reasonableÿ
belief that its own actual return on investment and/or cost of funds willÿ
differ from the applicable federal rate (which belief is supported byÿ
evidence and a certification), or (iii) the expectation that it will be anÿ
AMT taxpayer or will use credits to offset tax from the residualÿ
(supported by documentation and a certification). In addition toÿ
certification, the penalties of perjury statement suggested in Partÿ
IV.D.1. could be required. This modification to the proposed regulationÿ
would make it less likely that transferors would be required to pay anÿ
amount of consideration that exceeds the present value of the tax theÿ
transferee will actually be required to pay. This approach would not,ÿ
however, foreclose opportunities for abuse, and implementation may beÿ
difficult. For example, it may be difficult to evaluate the transferee'sÿ
assertions regarding its expected return on investment.

3. LIMIT SAFE HARBOR TRANSFERS TO WELL-CAPITALIZED TRANSFEREES. Underÿ
a third approach, the safe harbor would be limited to transfers toÿ
well-capitalized transferees that are unlikely to declare bankruptcy orÿ
otherwise experience financial distress that would cause them to defaultÿ
on their obligations. One natural class of transferees would be Cÿ
corporations that are also "qualified institutional buyers" ("QIBs"),ÿ
which generally have gross assets of at least $100 million. In addition,ÿ
this approach might require that the transferee have a minimum level ofÿ
pre-transfer net assets (such as the greater of $10 million or 100 timesÿ
the present value of the expected tax liability associated with theÿ
residual interest). This restriction might help prevent transfers ofÿ
noneconomic residuals to transferees that later declare bankruptcy, but itÿ
would exclude a large market for residual interests consisting ofÿ
substantial partnerships and less well-capitalized (but bona fide)ÿ
purchasers.

4. MANDATE SECONDARY LIABILITY FOR TRANSFERORS IN ALL INSTANCES.ÿ
Finally, it is possible that no approach will adequately prevent abusiveÿ
transfers. If that is the case, the safe harbor arguably should beÿ
repealed so that transferors would always be secondarily liable for tax onÿ
transferred residual interests. We have serious reservations about thisÿ
approach because it would either require REMIC sponsors to retain theÿ
contingent liability on their books, effectively restrict transfers toÿ
transferees with AAA credit ratings, or force transferors to seekÿ
insurance against the contingent liability, and in any case imposeÿ
transaction costs and reduce REMIC efficiency. Although this approach mayÿ
eventually prove necessary, we do not recommend it, at least until theÿ
alternatives we propose have been tried and found ineffective.

[42] We do recommend that, whatever approach is adopted, theÿ
effective date be no earlier than the date of enactment (if by statute) orÿ
issuance in final form (if by regulation). Accordingly, we recommend thatÿ
the effective date of proposed regulations section 1.860E-1(c)(4) beÿ
postponed until the regulation (or its replacement) is finalized.

FOOTNOTES