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 Bar
Association Tax Section1commenting on two
recent proposals intended to
prevent evasion of tax on residual interests in Real Estate Mortgage
Investment Conduits ("REMICs") and ownership interests in Financial Asset
Securitization Investment Trusts ("FASITs").
[2] One of the two proposals is legislative. The Administration's
Fiscal Year 2001 Budget proposed that REMICs be made secondarily liable
for tax owed by holders of their residual interests. Similarly, FASITs
would be made secondarily liable for tax owed by holders of their
ownership interests.
[3] The other proposal addressed in our report is regulatory. Early
this year, regulations were proposed that could effectively impose
secondary liability on transferors of REMIC residual interests (and FASIT
ownership interests) for tax owed by the transferee unless the amount paid
as consideration to the transferee at least equals the present value of
the tax, computed using certain assumptions that often are unrealistic.
Failure to pay this amount would prevent transferors from relying on a
"safe harbor" in current regulations, and thus subject them to the risk
that a transfer will be disregarded for tax purposes.
[4] Although we agree with the Treasury Department that changes in
current law are needed to reduce opportunities for evasion of tax on
income from residual interests, we believe that these proposals could
seriously and unnecessarily impede use of REMICs (and FASITs). In our
report, we propose other changes in the law that would, we believe,
adequately address any opportunities for tax evasion without imposing
unnecessary costs on securitization transactions.
[5] Because any tax owed by a REMIC (or FASIT) under the legislative
proposal generally would be paid from assets needed to make payments due
holders of regular interests, the proposal effectively imposes contingent
liability on regular interests for tax owed by residual interest holders.
Imposing contingent liability on regular interests could make it difficult
(or impossible) for such interests to be rated by rating agencies or
traded in the market. Congress enacted the REMIC rules in part to increase
the efficiency and liquidity of the mortgage market. By increasing the
costs of using REMICs and reducing liquidity in their regular interests,
the legislative proposal will undermine that purpose.
[6] Although its consequences may be less serious, the proposed
amendment to current regulations would also impede use of REMICs (and
FASITs). The proposed amendment would have this effect because it would
make transfers of residuals more difficult and expensive. REMIC sponsors
often are not the most efficient holders of residuals; in fact, some
sponsors may be precluded by law from holding residuals because they are
"disqualified organizations".
[7] As alternatives to these two proposals, the enclosed report
suggests several changes to current law to minimize opportunities for
avoidance of tax on income from REMIC residual interests (and FASIT
ownership interests). First, we propose expansion of the list of
"disqualified organizations" (which effectively cannot hold residuals) to
include Indian tribes and tribal corporations. Second, we propose that
issuance or transfer of an interest in a partnership or other pass-through
entity holding REMIC residual interests be treated as a transfer of those
interests, and thus as subject to the same restrictions that current law
imposes on direct transfers. Finally, we propose that the safe harbor in
current regulations (which gives transferors certainty that transfers will
not be disregarded) be converted into a substantive rule; thus, if its
requirements are not met, the transferor would be secondarily liable for
tax owed by the transferee. We also describe several other ways that
transfers of residuals might be restricted to address concerns about
abuse. Some of the changes described in our report would require
legislation, while others could be made by regulation.
[8] Please let me know if we can be of further assistance in
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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NEW 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's
Fiscal Year 2001 Budget to impose secondary liability on real estate
mortgage investment conduits ("REMICs") and financial asset securitization
investment trusts ("FASITs") for tax owed by holders of residual
interests. This report also comments on the proposed amendment to
regulations section 1.860E-1(c)(4) denying that provision's safe harbor to
transferors of noneconomic REMIC and FASIT residual interests unless the
consideration paid for the transfer and the residual's expected cash flows
together exceed the holder's net expected tax liabilities (all determined
on a present value basis and assuming the highest marginal corporate
rate).3
[10] We share the Treasury Department's concern that taxpayers may be
attempting to avoid tax on income allocable to holders of residual
interests, and we agree that current rules should be tightened to prevent
potential abuse.
However, we do not believe that secondary liability for
the residual holder's tax should be imposed on a REMIC.
4 Because tax
owed by a REMIC would be paid out of assets required to pay interest and
principal due regular interest holders, the burden of any tax imposed
under the proposal would fall on regular interest holders. Thus, the
practical effect of the proposal is to make holders of regular interests
secondarily liable for tax on income allocable to residual interest
holders.
[11] We object to burdening regular interest holders with tax that
residual holders fail to pay for the following reasons. First, a
contingent liability on regular interests would introduce uncertainty into
their pricing and adversely affect their liquidity. It would thereby tend
to frustrate the primary purpose of the REMIC rules, which was to increase
efficiency of capital markets. Second, because regular interest holders do
not have contact with residual interest holders, effectively imposing
contingent liability on regular interest holders is an inefficient means
of ensuring that residual interest holders pay tax. In this report, we
propose alternative changes to the rules governing transfers of residual
interests that would be more effective and efficient means of preventing
tax evasion.
[12] Rules facilitating transfers of residual interests increase the
economic efficiency of the REMIC vehicle and thus advance Congress's
objective in enacting the REMIC provisions. We recognize, of course, that
the goal of economic efficiency must be balanced against the need to
prevent abusive transfers of residual interests that may permit tax
evasion. Proposed regulations section 1.860E-1(c)(4) would, however, deny
the safe harbor to certain nonabusive transfers of residuals and thus
would unnecessarily reduce the economic efficiency of the REMIC vehicle
and of the mortgage market. To prevent abusive transfers of residuals
without unnecessarily reducing market liquidity, this report suggests that
the current safe harbor be converted into a substantive rule; thus, a
transferor that does not satisfy its requirements would be secondarily
liable for tax on income allocable to the transferred interest. We also
suggest additional safeguards to help assure that the residual interest
holder pays tax it owes.
[13] In short, we recommend as follows:
1. American Indian tribes and tribal corporations should be added to
the list of disqualified organizations.
2. The transfer of an interest in a partnership or other pass through
entity that holds a residual interest should be treated as a "transfer" of
the residual by the transferor, and the issuance of an interest in such an
entity should be treated as a transfer of the residual interest by the
pass through entity (i.e., an "aggregate approach" would be applied to the
residual). Accordingly, the putative transfer would be disregarded with
respect to the residual interest under existing rules if it was abusive.
3. Neither a REMIC nor its regular interest holders should be liable
for the tax liability of the residual holder.
4. The safe harbor in proposed regulations section 1.860E- 1(c)(4)
should be converted into a substantive rule that imposes secondary
liability for the residual tax liability on a transferor that does not
comply with it. We also suggest some possible additional restrictions.
II. BACKGROUND.
A. IN GENERAL.
[14] Congress enacted the REMIC provisions in 1986 to permit
mortgages to be pooled and interests in them sold without imposition of a
corporate-level tax, and to eliminate uncertainty regarding the tax
treatment of those interests. Thus, under the REMIC rules, the REMIC
entity is not generally subject to tax, and regular interests issued by
the REMIC are treated as indebtedness for federal income tax purposes and
are subject to a stable and widely- understood tax regime. The REMIC
provisions have largely succeeded in advancing Congress's goal of
increasing the liquidity of mortgage loans and the efficiency of the
mortgage markets. The FASIT provisions were enacted in 1997 to achieve
similar objectives for a broader class of assets.
[15] In the REMIC provisions, Congress also sought to assure that tax
would be paid on a specified amount of the "phantom income" of a REMIC
that arises when, in a "normal" interest rate environment (i.e., long-term
interest rates exceed short-term rates), long-term mortgages are financed
by issuance of different tranches of debt with varying maturities (as is
generally the case with REMICs). Accordingly, under section 860C, the
residual interest holder is subject to tax on the net income of the REMIC
and, in all events, is subject to tax on the REMIC's "excess inclusion
income," which is intended to be a proxy for the REMIC's phantom income.
5
The REMIC provisions impose three separate mechanisms to ensure that
tax on excess inclusion income may not be avoided by transfers to persons
that will not pay the tax. Each of these three mechanisms is discussed
below.
B. PENALTY TAX ON TRANSFERS TO DISQUALIFIED ORGANIZATIONS.
[16] First, to qualify as a REMIC, an entity must have in place
"reasonable arrangements" to prevent ownership of residual interests by
certain persons -- "disqualified organizations" -- that are not subject to
U.S. federal income tax.6
Moreover, the transfer of a residual interest
to a disqualified organization subjects the transferor to a penalty tax
equal to the highest marginal corporate rate times the present value of
anticipated excess inclusions for periods after the transfer.
7
A tax at
the highest marginal corporate rate is also imposed on the excess
inclusion income of any "pass through entity" to the extent allocable to
its disqualified organization interest holders.8
[17] Disqualified organizations include (i) the United States, its
states and political subdivisions, (ii) foreign governments and
international organizations (and their agencies and instrumentalities),
(iii) tax-exempt organizations not subject to the tax on "unrelated
business taxable income," and (iv) cooperatives described in section
1381(a)(2)(C).9
However, American Indian tribes and tribal corporations
are not included in this list.
[18] Under section 860E(e)(4) and its regulations, the transferor of
a residual interest is not subject to the section 860E(e) penalty tax if
the transferee furnishes to the transferor an affidavit containing the
transferee's social security number and a statement, signed under
penalties of perjury, that the transferee is not a disqualified
organization.10
C. RESTRICTIONS ON TRANSFERS OF "NONECONOMIC RESIDUALS" TO
DOMESTIC ENTITIES.
[19] Second, under regulations, if a "noneconomic residual interest"
11
is transferred to a domestic entity and a "significant purpose" of
the transfer is to impede the assessment or collection of tax, the
transfer is disregarded and the transferor remains liable for the tax on
the residual.12
A significant purpose to impede the assessment or
collection of tax is deemed to exist if the transferor knows or should
have known (i.e., the transferor has "improper knowledge") that the
transferee would be unwilling or unable to pay the taxes due on its share
of the REMIC's taxable income.13
On the other hand, under a safe
harbor, the regulations presume that the transferor does not have improper
knowledge if it (i) conducts a reasonable investigation of the financial
condition of the transferee and, as a result of the investigation, finds
that the transferee has historically paid its debts as they came due and
there exists no significant evidence to indicate that the transferee will
not continue to pay its debts as they come due in the future, and (ii)
receives a representation that the transferee understands that, as a
holder of a noneconomic residual interest, it may incur tax liabilities in
excess of cash flows generated by the interest and that the transferee
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 for
noneconomic residual transfers to domestic transferees, the regulations
provide that the transfer of a residual interest with "tax avoidance
potential" to a foreign person that does not report the residual interest
income as effectively connected with its U.S. trade or business also is
disregarded and the transferor remains liable for the tax on the residual.
15
In general, a residual interest has tax avoidance potential if the
cash flows of the residual interest are insufficient to satisfy a 30%
withholding tax on excess inclusion income.16
Under a safe harbor, a
residual interest is not treated as having tax avoidance potential (and
thus the transfer is not disregarded) if, based on each prepayment speed
between 50% and 200% of the REMIC's assumed prepayment speed, the REMIC
would distribute enough cash to satisfy the 30% tax.
17 For a residual
that is treated as not having tax avoidance potential, no representation
from the transferee is needed to ensure that the transfer is not
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 the
REMIC provisions was to ensure that, in all events, tax is paid on a
REMIC's excess inclusion income. The Treasury Department, the Joint
Committee on Taxation and commentators have identified at least three
potential methods by which taxpayers may nevertheless attempt to avoid
this liability.
[22] First, American Indian tribes and tribal corporations organized
under federal law are not subject to U.S. federal income tax,
18 but
Congress neglected to include them in the list of disqualified
organizations. One commentator has speculated that REMIC residuals are
held by American Indian tribes, and that the associated excess inclusion
income escapes tax.19
[23] Second, the restrictions on transfers of noneconomic interests
and residual interests with tax avoidance potential arguably do not apply
to transfers of interests in partnerships or other pass through entities
that own residuals, or to issuances of interests in these entities. Thus,
a U.S. taxpayer that owns a negative value residual in a domestic
partnership could cause the partnership to issue interests to foreign
persons, and claim that the issuance is not a "transfer" of the residual
interest. In fact, the Internal Revenue Service ("IRS") is currently
litigating such a case in Tax Court.20
[24] Finally, a bankruptcy proceeding may excuse a residual holder
from tax liability on the excess inclusion income. Thus, conceivably, a
noneconomic residual interest could be purchased by a corporation that
subsequently declares bankruptcy, and the tax liability would be
discharged. Unless the transferor "knew or should have known" that the
corporate transferee would be unwilling or unable to pay tax on income
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 that
taxpayers may be evading tax on income from residual interests. To address
potential abuses, in February 2000, the Treasury Department proposed
regulatory and statutory amendments to prevent abusive residual interest
transfers.
[26] First, as part of the FASIT proposed regulations package issued
on February 4, 2000, Treasury and the IRS proposed an additional condition
for the safe harbor under regulations section 1.860E-1(c)(4) for transfers
of noneconomic REMIC residuals (and FASIT ownership interests). Under the
proposed regulation, the safe harbor would be available only if the
present value of the anticipated tax liabilities associated with holding
the residual interest (computed based on the highest marginal corporate
tax rate)21
does not exceed the sum of (i) the present value of any
consideration paid 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. The change is proposed
to be effective for transfers on and after February 4, 2000.
[27] Second, as part of the Administration's Fiscal Year 2001 Budget
Revenue Proposals, the Treasury Department proposed to make REMICs and
FASITs secondarily liable for tax owed by holders of residual interests.
Because tax owed by a REMIC or FASIT would be paid from assets otherwise
used to make payments due regular interest holders, the proposal would
effectively impose secondary liability on holders of regular interests to
the extent of their value. The provision is proposed to be effective for
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 that
certain taxpayers may be attempting to avoid residual interest tax.
However, we believe that the proposal to impose secondary liability for
the residual tax on REMICs and FASITs (and, in practical effect, on their
regular interest holders) would significantly impair the effectiveness of
these vehicles and thus frustrate Congress's purpose in creating them. We
also believe that it is not the best means of insuring that the tax is in
fact paid.
[29] Effective securitization of assets requires that the
securitization vehicle not be subject to the claims of third-party
creditors. The proposal to impose secondary liability on a REMIC or FASIT
for tax owed by its residual interest holder (or owner) would violate this
requirement. We understand that, if this proposal were enacted, the
contingent tax liability on the REMIC or FASIT would adversely affect the
credit rating of regular interests issued by "private label REMICs,"
22
and would preclude a "AAA" rating for any class of regular interests
without additional reserves to cover the contingent liability. Requiring
REMICs to hold additional reserves would defeat the purpose of providing
an economically efficient vehicle for securitizing mortgage loans.
23
[30] Second, we do not believe that the proposal would help ensure
that residual holders in fact pay their tax liability. Although regular
interest holders would bear the economic burden of tax not paid by the
residual interest holder, because regular interest holders rarely (and in
public transactions never) have privity with the residual holder, they
would be unable to ensure that the residual holder actually pays its tax.
We believe that it is possible to address the problem of abusive transfers
of residuals without affecting the liquidity of regular interests;
therefore we oppose imposition of secondary liability for the residual
interest tax on the REMIC (and, by extension, on its regular interest
holders).
[31] Proposed regulations section 1.860E-1(c)(4) presents more
difficult issues. Residual interest liquidity generally improves the
economic efficiency of the REMIC vehicle (and, consequently, the mortgage
market). The goal of increasing efficiency of the mortgage market must, of
course, be balanced against the need to prevent tax evasion. We suggest a
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 tribal
corporations holding residual interests. Nevertheless, we recommend that
section 860E(e)(5) be amended to add American Indian tribes and tribal
corporations organized under federal law to the list of disqualified
organizations. The Treasury Department should also be granted regulatory
authority to add additional entities that are not subject to federal
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 other
flow-through vehicles to avoid tax on negative value residuals, we
recommend that the certification requirements of regulations sections
1.860E-1(c) and 1.860G-3 be amended to provide that the transfer of a
beneficial interest in a partnership, trust, estate, or other "pass
through" entity (as defined in section 860E(e)(6)(B)) that holds a
residual interest is treated as a "transfer" of the residual by the
transferor, and to provide that the issuance of an interest in such an
entity is treated as a "transfer" of the residual interest by the pass
through entity. Accordingly, the putative transfer (with respect to the
residual only, and not the entity's other assets) would be disregarded
under existing rules if abusive.
[34] The existing certification safe harbors would apply to transfers
of interests in flow-through entities. Moreover, a certification from the
transferee of an interest in a pass through entity would not be necessary
if a representative of the pass through entity certifies (under penalties
of perjury) in the year of the transfer that the entity's cash flows to
the transferee from the residual and its other assets (less applicable
withholding) are expected to be sufficient to pay the transferor's tax
liability with respect to the residual in each year based on prepayment
speeds between 50% and 200% of the REMIC's assumed prepayment speed.
24
[35] The amendment would not affect the ability of the IRS under
current law to attack the use of a partnership or other entity to avoid
residual tax liability under the existing anti-abuse rules and other
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 either
impossible, unfeasible, or otherwise economically inefficient for a REMIC
sponsor to retain a noneconomic residual interest. For example, because
GNMA is a disqualified organization, it is not permitted to hold the
residuals from the REMICs it sponsors. In addition, mortgage origination
(and not cash flow management) is the core business of many REMIC
sponsors, and they generally do not have the professional personnel to
manage the liability represented by a REMIC residual and to efficiently
invest the cash reserves necessary to fund the liability. Accordingly, as
a matter of efficient balance sheet management, these sponsors prefer to
transfer the residual (and the liability it represents) to a party that is
better able to manage it.
[37] Rules that require REMIC sponsors to increase the amounts they
pay to transfer residuals (or, worse, that preclude them from transferring
residuals), increase their cost of doing business. All or a portion of
this increased cost, in turn, is passed along through the market as an
additional cost of mortgage lending and ultimately increases mortgage
interest rates. In contrast, rules that minimize consideration REMIC
sponsors must pay to transfer noneconomic residuals generally minimize
their cost of doing business, which improves the efficiency of the
mortgage market. We believe that enhancing efficiency of the mortgage
market is an important policy goal and was a major purpose of the REMIC
regime.
[38] The proposed regulation would require that the consideration for
the transfer plus the residual interest's future cash flow exceed the tax
liability associated with the residual, based on the highest marginal
corporate income tax rate and the present value of expected future
distributions, discounted at the applicable federal rate (or lower rate
only if the transferee can demonstrate a lower borrowing rate). This
proposed formula may overstate the consideration that a transferee would
demand if the transferee is able to invest the payment at a rate that
exceeds the applicable federal rate. Moreover, market changes after the
REMIC is organized may cause the expected prepayment rate to be higher at
the time of the transfer of the residual than the REMIC's prepayment
assumption, thereby also justifying the payment of less consideration, and
the proposed regulation is unclear as to whether the transferee may take
into account these market changes in determining the present value of the
net tax liabilities associated with the residual. AMT taxpayers may be
subject to a marginal rate of 20%, rather than 35%, on their excess
inclusion income during some or all periods. Finally, taxpayers are
permitted to offset tax on excess inclusions by certain credits, such as
low-income housing tax credits, also resulting in an effective tax rate
that is less than the highest marginal rate. Therefore, the proposed
regulation is overbroad and denies safe harbor treatment for many
nonabusive transfers. Moreover, to the extent the proposed regulation does
not increase the likelihood that the residual tax will be paid, it is
unsuited to the task of preventing abuse.
[39] Although the proposed regulation would affect only a "safe
harbor," in practice, because the stakes are so high for the transferor of
a noneconomic residual interest (i.e., the transferor pays the transferee
to accept the residual and, if the transfer is disregarded, the transferor
is out the payment and is subject to tax), the safe harbor has effectively
become the substantive rule for major REMIC transactions and is regularly
incorporated into transaction documents. As a practical matter, therefore,
the proposed regulation would effectively preclude or impede nonabusive
transfers of residuals, and thus would make mortgage securitizations using
REMICs less efficient.
[40] Nevertheless, we recognize that the policy goal of economic
efficiency must be balanced against the policy goal of preventing tax
evasion through abusive residual transfers. To minimize opportunities for
evasion, without unnecessarily impeding transfers of residuals, we
recommend that the safe harbor of regulations section 1.860E-1(c)(4) be
converted into a substantive rule, so that any transferor not complying
would be secondarily liable for tax on income from the transferred
residual. In other words, if a transferor does not comply with the
regulation's requirements to conduct an investigation of the financial
condition of the transferee and receive a representation from the
transferee as to its intent to pay the tax, and the transferee does not in
fact pay the residual tax liability, the transferor would remain liable
for the tax and would not be permitted to escape liability by
demonstrating that it did not know and should not have known that the
transferee would fail to pay the tax. (However, if the tax is in fact paid
by the transferee, the transfer would be respected even if the transferor
does not comply with the safe harbor.) We believe this change will help
prevent abusive residual transfers without adversely affecting residual
liquidity. If this change is not sufficient to prevent residual abuse, we
suggest below a number of alternatives to proposed regulations section
1.860E-1(c)(4) that attempt to balance the goals of maximizing liquidity
for noneconomic residuals and preventing abuse.
1. PENALTIES OF PERJURY STATEMENT BY CFO (OR EQUIVALENT OFFICER) OF
THE TRANSFEREE. First, regulations sections 1.860E-1(c)(4) could be
amended to impose the additional requirement that the transferor receive a
certification from the chief financial officer (or equivalent officer) of
the transferee, signed under penalties of perjury, that the CFO has
personal knowledge of the financial condition of the transferee and, to
the best of the CFO's knowledge, all tax liability with respect to the
residual will in fact be paid (even if it exceeds the transferee's
projections). In the case of any transferee that is a pass through entity,
the certification would be received from the CFO (or equivalent officer)
of each beneficial owner.25 The safe harbor would not be available if
the transferor knew or had reason to know that the certification was
false. In addition, transfers of residuals would be reported to the IRS
along with the penalties of perjury statement.
[41] Requiring certification under penalties of perjury by an
individual senior officer of the transferee would (i) place responsibility
where it belongs -- on an individual responsible for the transferee's
activities, (ii) permit maximum flexibility for nonabusive residual
interest transfers,26
and (iii) ensure residual liquidity and therefore
maximize economic efficiency. Of course, a penalties-of-perjury statement
would not absolutely ensure payment of the residual tax. Even assuming the
statement is made in good faith, abuses could occur after the signatory
resigns as an officer of the transferee. It is also possible, although
less likely, that a transferee would hire a CFO solely to sign the
statement.
2. MODIFIED PROPOSED REGULATION. Under a second approach, a modified
version of the proposed regulation would be adopted permitting transfers
for less consideration than generally required if the transferor could
justify the lesser amount by considerations such as (i) a reasonable
belief that its own actual return on investment and/or cost of funds will
differ from the applicable federal rate (which belief is supported by
evidence and a certification), or (iii) the expectation that it will be an
AMT taxpayer or will use credits to offset tax from the residual
(supported by documentation and a certification). In addition to
certification, the penalties of perjury statement suggested in Part
IV.D.1. could be required. This modification to the proposed regulation
would make it less likely that transferors would be required to pay an
amount of consideration that exceeds the present value of the tax the
transferee will actually be required to pay. This approach would not,
however, foreclose opportunities for abuse, and implementation may be
difficult. For example, it may be difficult to evaluate the transferee's
assertions regarding its expected return on investment.
3. LIMIT SAFE HARBOR TRANSFERS TO WELL-CAPITALIZED TRANSFEREES. Under
a third approach, the safe harbor would be limited to transfers to
well-capitalized transferees that are unlikely to declare bankruptcy or
otherwise experience financial distress that would cause them to default
on their obligations. One natural class of transferees would be C
corporations that are also "qualified institutional buyers" ("QIBs"),
which generally have gross assets of at least $100 million. In addition,
this approach might require that the transferee have a minimum level of
pre-transfer net assets (such as the greater of $10 million or 100 times
the present value of the expected tax liability associated with the
residual interest). This restriction might help prevent transfers of
noneconomic residuals to transferees that later declare bankruptcy, but it
would exclude a large market for residual interests consisting of
substantial partnerships and less well-capitalized (but bona fide)
purchasers.
4. MANDATE SECONDARY LIABILITY FOR TRANSFERORS IN ALL INSTANCES.
Finally, it is possible that no approach will adequately prevent abusive
transfers. If that is the case, the safe harbor arguably should be
repealed so that transferors would always be secondarily liable for tax on
transferred residual interests. We have serious reservations about this
approach because it would either require REMIC sponsors to retain the
contingent liability on their books, effectively restrict transfers to
transferees with AAA credit ratings, or force transferors to seek
insurance against the contingent liability, and in any case impose
transaction costs and reduce REMIC efficiency. Although this approach may
eventually prove necessary, we do not recommend it, at least until the
alternatives we propose have been tried and found ineffective.
[42] We do recommend that, whatever approach is adopted, the
effective date be no earlier than the date of enactment (if by statute) or
issuance in final form (if by regulation). Accordingly, we recommend that
the effective date of proposed regulations section 1.860E-1(c)(4) be
postponed until the regulation (or its replacement) is finalized.
