Financial Asset Securitization Investment Trusts; Real Estate Mortgage Investment Conduits

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and notice of public hearing.

SUMMARY:

This document contains proposed regulations relating to financial asset securitization investment trusts (FASITs). This action is necessary because of changes to the applicable tax law made by the Small Business Job Protection Act of 1996. The proposed regulations affect FASITs and their investors. This document also contains proposed regulations relating to real estate mortgage investment conduits (REMICs). This document provides notice of a public hearing on the proposed regulations.

DATES:

Written comments must be received by May 8, 2000. Outlines of topics to be discussed at the public hearing scheduled for May 15, 2000 at 10 a.m., must be received by April 24, 2000.

ADDRESSES:

Send submissions to CC:DOM:CORP:R (REG-100276-97 and REG-122450-98), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-100276-97), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments via the Internet by selecting the “Tax Regs” option of the IRS Home Page or by submitting them directly to the IRS Internet site at http://www.irs.gov/tax_regs/regslist.html. The public hearing will be held in Room 2615, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations other than issues relating specifically to cross border transactions, David L. Meyer at (202) 622-3960 (not a toll-free number) and for issues relating specifically to cross border transactions, Rebecca Rosenberg or Milton Cahn at (202) 622-3870 (not a toll-free number); concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Guy Traynor at (202) 622-7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). 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, OP:FS:FP, Washington, DC 20224. Comments on the collection of information should be received by April 7, 2000.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the Internal Revenue Service, including whether the collection will have a practical utility;

The accuracy of the estimated burden associated with the proposed 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 proposed 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 startup costs and costs of operation, maintenance, and purchase of services to provide information.

The collection of information is in § 1.860H-1(b)(2) and § 1.860H-6(e). This information is required to permit qualified entities to elect to become a Financial Asset Securitization Investment Trust and to ensure the holder of the ownership interest in a FASIT properly reports the FASIT's items of income, gain, deduction, loss, and credit. This information will be used to properly administer the provisions of part V of subchapter M of the Code. The collection of information is mandatory. The likely respondents are business or other for-profit institutions.

Estimated total annual reporting and/or record keeping burden: 750 hours.

Estimated average annual burden hours per respondent and/or record-keeper: 5 hours.

Estimated number of respondents and/or record-keepers: 150.

Estimated annual frequency of responses: one annually.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

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 information are confidential, as required by 26 U.S.C. 6103.

Background

Section 1621(a) of the Small Business Job Protection Act of 1996, Public Law 104-188, 110 Stat. 1755 (August 20, 1996) (the Act) amended the Internal Revenue Code (Code) by adding part V (sections 860H through 860L) (the FASIT provisions) to subchapter M of chapter 1. Part V, which is effective September 1, 1997, authorizes a securitization vehicle called a Financial Asset Securitization Investment Trust (FASIT). FASITs are meant to facilitate the securitization of debt instruments, including non-mortgage and mortgage debt instruments.

A solicitation for comments was published in the Federal Register for November 4, 1996 (61 FR 56647). The comments received both raised and helped resolve significant issues. The IRS and Treasury request comments on these proposed regulations generally, and specifically request suggestions on how they may be revised to be more easily understood.

Explanation of Provisions

In General

A FASIT is a qualified arrangement that elects FASIT treatment and meets certain requirements concerning the composition of its assets and the interests it issues to investors. A qualified arrangement can be a corporation (other than a regulated investment company (RIC) as defined in section 851(a)), partnership, trust, or segregated pool of assets.

A FASIT may issue one or more classes of regular interests, which are treated as debt for all purposes of the Code. In addition, each FASIT must have a single ownership interest, which must be held entirely by a non-exempt domestic C corporation (other than a RIC, real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), or subchapter T cooperative).

A FASIT is not subject to income tax. Instead, the tax items of the FASIT are included in the taxable income of the holder of the ownership interest (the Owner). The Owner, (and in some circumstances a person related to the Owner) must recognize gain (if any) when property is either transferred to the FASIT or supports the regular interests.

Congress enacted the FASIT provisions to facilitate the securitization of revolving, non-mortgage debt obligations. An anti-abuse rule incorporated in these proposed regulations is designed to ensure that FASITs are used in a manner that is consistent with this intent and not to create opportunities for tax planning that would not exist but for the enactment of the FASIT provisions and these proposed regulations.

Rules Applicable to the FASIT

Administrative Provisions

1. Background

The administrative provisions have three objectives: (1) ensuring accurate and timely reporting of the FASIT's tax items, (2) ensuring compliance by the FASIT with the operating and qualification rules, and (3) reducing administrative burdens on FASIT interest holders and the IRS.

2. FASIT Election

The proposed regulations provide that a FASIT election is made by attaching a statement to the Owner's Federal income tax return for the taxable year that includes the startup day. No particular form is presently required, but the statement must be specified as a FASIT election, and must identify the arrangement for which the election is made. The IRS and Treasury want to ensure that the persons most affected by a FASIT election have agreed to make the election. Therefore, if the electing arrangement is an entity, the election statement must be signed by the person who would sign the entity's return in the absence of the FASIT election. If the electing arrangement is a segregated pool of assets, the election statement must be signed by each person that owns the assets in the pool for Federal income tax purposes immediately before the startup day.

3. Treatment of FASIT Under Subtitle F

None of the FASIT provisions addresses how a FASIT is treated under subtitle F (Procedure and Administration), which governs matters such as returns, penalties, tax payments, and assessments. One rule considered was to make a FASIT's subtitle F treatment depend on the classification of the electing arrangement. Thus, for example, if a partnership makes a FASIT election, the FASIT is a partnership for purposes of subtitle F. Rather than adopt this approach, which leads to several different administrative regimes for FASITs, the proposed regulations treat each FASIT as a branch or division of its Owner for purposes of subtitle F. Because an Owner must always be a domestic C corporation, this solution results in uniform treatment.

The proposed regulations also make the Owner responsible for reporting interest income with respect to the regular interests which are treated for reporting purposes as collateralized debt obligations (CDOs).

Relationship of a FASIT to the Owner

The FASIT provisions do not provide a general rule defining the relationship between a FASIT and its Owner for non-FASIT Federal income tax purposes. The nature of this relationship may be relevant in determining the Federal income tax consequences of a number of transactions entered into with a FASIT. For example, it is necessary to know the extent to which transactions with a FASIT are treated as transactions with the Owner in determining how the portfolio interest exception applies and whether a change in the Owner of the FASIT results in a realization event for holders of the FASIT regular interests.

The IRS and Treasury considered proposing a general rule to characterize the FASIT's relationship to its Owner for all non-FASIT Federal income tax purposes. Among the alternatives evaluated were (1) treating the FASIT as an entity separate from the Owner; (2) treating the FASIT as a branch of the Owner; and (3) treating the FASIT as an entity for some purposes and as a branch for others.

Each alternative has some underpinning in the statutory scheme. For example, in determining the Owner's taxable income, the FASIT provisions treat a FASIT's assets, liabilities, and tax items as the assets, liabilities, and tax items of the Owner. This supports treating a FASIT as a branch of the Owner. However, the restrictions on what kind of assets may be held and what type of investor interests may be issued apply to the FASIT alone and favor treating a FASIT as a separate entity.

The IRS and Treasury have decided it is better to resolve the nature of the FASIT's relationship with the Owner on an issue-by-issue basis rather than by adopting a single general rule. A few situations (for example, the treatment of a FASIT under subtitle F and the treatment of a FASIT under the portfolio interest rules) are addressed in these proposed regulations. The IRS and Treasury welcome additional comments on whether and how additional rules should detail the FASIT's relationship with the Owner for non-FASIT Federal income tax purposes.

Assets That May Be Held by a FASIT (Permitted Assets)

1. Background

Except during a brief formation period, substantially all of a FASIT's assets must consist of permitted assets. Permitted assets include cash and cash equivalents, debt instruments (and rights to acquire debt instruments), foreclosure property, interest and currency hedges (and rights to acquire interest and currency hedges), guarantees (and rights to acquire guarantees), regular interests in other FASITs, and regular interests in REMICs. The FASIT provisions generally do not allow a FASIT to hold debt instruments issued by the Owner (or a related person).

Several commentators requested guidance on whether certain assets qualified as permitted assets. Other comments focused on the prohibition on Owner debt. In particular, the commentators requested guidance on the extent to which an Owner may guarantee assets or enter into a permitted hedge with the FASIT without violating the prohibition on Owner debt.

2. “Substantially All”

The FASIT provisions require substantially all of a FASIT's assets to be permitted assets. Under the proposed regulations, a FASIT meets this test if the aggregate adjusted basis of its assets other than permitted assets is less than one percent of the aggregate adjusted basis of all its assets.

The proposed rule is patterned after a safe harbor rule applicable to REMICs. The proposed regulations do not incorporate a provision in the REMIC safe harbor that allows a qualified entity that fails the REMIC safe harbor to otherwise demonstrate that it does not own more than a de minimis amount of non-qualified assets. This provision does not appear necessary because a FASIT, unlike a REMIC, can acquire additional permitted assets if it is in danger of failing the substantially all test.

3. Cash and Cash Equivalents

The FASIT provisions treat cash and cash equivalents as permitted assets. The proposed regulations generally define the phrase cash and cash equivalents to mean functional currency. Investment quality debt instruments that are close to maturity are also cash and cash equivalents because of their perceived liquidity.

In response to some commentators, the proposed regulations provide that cash and cash equivalents include shares in U.S.-dollar-denominated money market mutual funds. Although such shares are technically stock, money market mutual funds are practical investments for cash balances pending either distribution to regular interest holders or reinvestment in new debt instruments. The IRS and Treasury, therefore, believe it is appropriate to allow FASITs to hold these investments.

4. Debt Instruments in General

Under the FASIT provisions, a debt instrument must satisfy two criteria to be a permitted asset. First, it has to be a debt instrument as defined in section 1275(a)(1) of the Code, which means it has to be a bond, debenture, note or certificate, or other evidence of indebtedness. Second, interest payments (if any) must be made in the manner prescribed for REMIC regular interests. Interest payments on REMIC regular interests must be based on a fixed or variable rate (as allowed in regulations), or must consist of a specified portion of the interest payments on the underlying mortgages held by the REMIC. This means that under the FASIT provisions, interest payments on a debt instrument held by a FASIT must also be payable at a fixed or variable rate, or consist of a specified portion of the interest payments on some underlying debt instrument.

The proposed regulations enumerate the types of debt instruments that meet this standard and therefore qualify as permitted assets. In general, a FASIT may hold fixed-rate debt instruments, specified floating-rate debt instruments, inflation-indexed debt instruments, and credit card receivables. In response to comments received, the proposed regulations also clarify that a FASIT may generally hold beneficial interests in, or coupon and principal strips created from, these instruments.

One commentator requested that the proposed regulations specifically allow FASITs to hold debt instruments that provide for prepayment penalties. The commentator's concern was that prepayment penalties might be viewed as contingent payments that are not fixed or variable interest payments within the meaning of the FASIT provisions. The proposed regulations accommodate this concern by including in the list of permitted debt instruments, debt instruments to which § 1.1272-1(c) (relating to debt instruments that provide for alternate payment schedules) applies. These rules generally accommodate prepayment penalties.

To prevent a FASIT from indirectly holding equity-like or other non-debt interests, the proposed regulations disqualify any debt instrument that can be converted into, or the value of which is based on, anything other than a permitted debt instrument. Impermissible debt instruments include, for example, a debt instrument convertible into stock and a debt instrument the interest payments on which vary based on the spot price of oil. The proposed regulations also do not permit a FASIT to hold debt instruments that, when acquired by the FASIT, are in default due to any payment delinquency unless the Owner reasonably expects the obligor to cure the default (including the payment of any interest and penalties) within 90 days of the date the instrument is acquired by the FASIT. The concern is that a distressed debt instrument may take on the characteristics of equity because the FASIT (and in turn the regular interest holders): (1) may have to look to the obligor's general assets for payment of the instrument, (2) may not receive full payment of the instrument, and (3) may not receive any payment until the satisfaction of claims held by the obligor's other creditors.

5. Participation Interests

One commentator requested guidance on whether a participation interest in a pool of revolving loans would be considered a permitted asset. The commentator pointed out that a participation interest can be based either on a fixed percentage of assets in the pool or on a fixed dollar amount of assets in the pool.

The proposed regulations do not specifically address participation interests. It does not appear that guidance is needed concerning participation interests that are based on a fixed percentage of assets. If a FASIT owns a fixed-percentage participation interest, as the outstanding principal balance of the pool rises and falls, the FASIT may be required to pay additional amounts or entitled to receive distributions to maintain its fixed percentage ownership in the pool. As long as the distributions are paid in cash (or in the form of an otherwise permitted asset), the FASIT's fixed-percentage interest should be considered a fixed-percentage interest in each of the debt instruments in the pool. Thus, the FASIT's fixed-percentage participation interest should qualify as a permitted debt instrument to the extent the underlying debt instruments are themselves permitted assets.

The result under the FASIT provisions is less clear in cases where the participation interest is based on a fixed dollar amount of assets in a pool. In this case, each change in the outstanding balance of the pool would trigger a corresponding change in the FASIT's percentage ownership of the pool. When the size of the pool increases, the FASIT could be viewed as exchanging an interest in each asset in the old pool for a lower percentage interest in each asset in the new pool. This exchange might constitute an impermissible asset disposition. In some cases, this disposition could result in the imposition of the prohibited transaction tax.

While the problem with fixed-dollar participation interests might be resolved by treating a pool as a single asset, a rule specifically allowing a FASIT to hold participation interests may be used as a means of inappropriately avoiding other rules. The IRS and Treasury welcome additional comments on whether and how the need for a FASIT to hold fixed-dollar amount participation interests can be accommodated.

6. Debt Instruments Issued by the Owner

To ensure that the holders of the regular interests are looking primarily to the FASIT, and not the Owner, for payment, the FASIT provisions generally prohibit a FASIT from holding debt instruments issued either by the Owner or a person related to the Owner (collectively, Owner debt). An exception is made for cash equivalents and other instruments specified by regulation.

Under the proposed regulations, Owner debt means more than just debt instruments issued by the Owner. It includes an obligation of the Owner embedded in another instrument, a third party debt instrument the performance of which is contingent on the performance of Owner debt, and any partial interest in Owner debt such as a principal or coupon strip. Similarly, a debt instrument guaranteed by an Owner is treated as Owner debt, if at the time the FASIT acquires the debt instrument, the Owner is in substance the primary obligor of the debt instrument. See Rev. Rul. 97-3 (1997-1 C.B. 9).

Cash equivalents of the Owner, which are permitted under the FASIT provisions, are limited by the proposed regulations to short-term investment quality debt instruments that are acquired to temporarily invest cash pending either distribution to the FASIT interest holders or re-investment in other permitted assets.

One commentator noted that under the FASIT provisions, it is unclear whether the Owner of two or more FASITs may use regular interests from one FASIT to fund another of its FASITs. If regular interests are considered debt of the Owner, then, technically, the regular interests held by the second FASIT would be impermissible Owner debt. The commentator noted that this form of tiering arrangement is commonly used in REMICs and should be available for use with FASITs. In response to this comment, the proposed regulations allow this type of tiering arrangement. As discussed below, however, tiered FASITs may not be used to achieve benefits that could not be obtained without the FASIT provisions.

7. Foreclosure Property

The FASIT provisions allow a FASIT to hold an asset (foreclosure property) acquired upon the default or imminent default of a permitted debt instrument. The FASIT provisions generally allow a FASIT to retain foreclosure property for a designated grace period of approximately three to four years. After the grace period, a 100-percent tax is imposed on any net income derived from the foreclosure property, including income from its operation or disposition.

In some cases, the property acquired upon foreclosure may independently qualify as another type of permitted asset. Under the proposed regulations, the FASIT may retain this type of foreclosure property beyond the grace period. If the FASIT retains the property beyond the grace period, the property loses its status as foreclosure property at the end of the grace period.

At this point, the proposed regulations require the Owner to recognize gain, if any, on the property as if it had been contributed to the FASIT at the close of the grace period. In addition, after the grace period, the property can no longer qualify for the foreclosure exception to the prohibited transaction rules.

8. Contracts or Agreements in the Nature of a Line of Credit

A FASIT may generally hold as a permitted asset a contract or agreement in the nature of a line of credit as long as the FASIT does not originate the contract or agreement.

9. Guarantees and Hedges

Under the FASIT provisions, a contract may qualify as a permitted asset if it is a permitted hedge or guarantee. The FASIT provisions impose two requirements on permitted hedges and guarantees. First, the contract must be an interest rate or foreign currency notional principal contract, letter of credit, insurance, guarantee against defaults, or other similar instrument. Second, the contract must be reasonably required to guarantee or hedge against the FASIT's risks associated with being the obligor on the interests that the FASIT has issued. Several commentators asked for guidance on the scope of this rule.

The proposed regulations provide guidance as to what constitutes a permitted hedge or guarantee. Rather than focus on the type of contract, the proposed regulations focus on its intended function. Under the proposed regulations, a contract is a permitted hedge or guarantee if the contract is reasonably required to offset differences that specified risk factors may cause between the amount or timing of the cash flows on a FASIT's assets and the amount or timing of the cash flows on the FASIT's regular interests. The specified risk factors are (1) fluctuations in market interest rates, (2) fluctuations in currency exchange rates, (3) the credit quality of the FASIT's assets and regular interests, and (4) the receipt of payments on the FASIT's assets earlier or later than originally anticipated.

Several commentators requested that the proposed regulations list specific types of hedges and guarantees that qualify as permitted assets. Because the proposed regulations define permitted assets and guarantees in terms of their function, the proposed regulations do not include this type of list. Out of a concern that hedges could be used to effect the economic equivalent of a transfer of non-permitted assets to the FASIT, the proposed regulations prohibit a hedge or guarantee from referencing certain assets and indices. In particular, a hedge is not a permitted hedge if it references an asset other than a permitted asset or if it references an index, economic indicator or financial average that is not widely disseminated and designed to correlate closely with changes in one or more of the four specified risk factors.

One commentator requested that the proposed regulations permit the incidental hedging of assets allocable to ownership interests. The commentator suggested that, as a practical matter, an Owner may desire to hedge all of the FASIT's assets inside the FASIT even though the FASIT securitizes less than all of the assets. The proposed regulations accommodate this concern by allowing the FASIT to hedge assets held (or to be held) and liabilities issued (or to be issued). Thus, under the proposed regulations, an Owner can hedge assets inside a FASIT that currently relate to the ownership interest if the assets are being held inside the FASIT because the Owner intends for them to support FASIT regular interests in the future.

The proposed regulations provide special rules for hedges and guarantees entered into with the Owner or a related party. These rules generally allow a FASIT to enter into a hedge (other than a credit hedge) with the Owner (or a related party) if two conditions are met. First, the Owner (or related party) must be a dealer with respect to that type of hedging contract. Second, the Owner must maintain records establishing that the hedge contract was entered into at arm's length. In addition, the special rules provide that an Owner (or a related party) may issue a guarantee to a FASIT if the Owner can demonstrate that, immediately after the guarantee is issued, less than three percent of the value of the FASIT's assets are attributable to Owner guarantees.

Finally, the usefulness of a hedge is diminished if the tax character of the hedge (as an ordinary or capital asset) does not match the tax character of the hedged item. Absent a special rule, disposing of a FASIT hedge could generate capital loss even though the associated assets and liabilities of the FASIT generate ordinary income and deductions. To alleviate this character mismatch, the proposed regulations treat a permitted hedge as an ordinary asset.

Prohibited Transactions

1. Background

The FASIT provisions restrict the types of transactions in which a FASIT may engage through the imposition of a prohibited transactions tax. The tax is equal to 100 percent of the income a FASIT realizes from a prohibited transaction. The four categories of prohibited transactions set out in the FASIT provisions include the receipt of any income from a loan originated by the FASIT and the receipt of gains from the FASIT's disposition of its assets.

2. Loan Origination

Commentators expressed considerable concern over the lack of statutory guidance on determining whether a debt instrument held by a FASIT has been originated by the FASIT. Commentators noted that debt instruments originated through the Owner's business activities might be deemed to be originated by the FASIT thereby exposing the FASIT to liability for the prohibited transactions tax on any income realized on the instrument.

The proposed regulations contain five safe harbors to limit the scope of the prohibited transaction rules as they relate to loan origination. Under the first safe harbor, a FASIT is not considered to have originated a loan if the FASIT acquires the loan from an established securities market.

Under the second safe harbor, a FASIT is not considered to have originated a loan if the FASIT acquires the loan more than a year after the loan was created.

Under the third safe harbor, a FASIT is not considered to have originated a loan if the FASIT acquires the loan from a person that regularly originates similar loans in the ordinary course of its trade or business. Importantly, this third safe harbor extends to transactions entered into with the Owner (or a related party). As a result, a FASIT that acquires credit card receivables from its Owner (or a related party), or creates new receivables from issuances made on accounts held by the FASIT will not be considered to have originated the receivables to the extent the Owner (or related party) originates similar loans in the ordinary course of its business.

The fourth safe harbor provides that the FASIT will not be treated as originating any new loan it may receive from the same obligor in exchange for the obligor's original loan in the context of a workout.

Finally, a FASIT will not be treated as having originated a debt instrument when it makes a loan pursuant to a contract or agreement in the nature of a line of credit the FASIT is permitted to hold.

3. Substitution or Distribution of Debt Instruments

The FASIT provisions generally impose a prohibited transaction tax on the distribution of debt instruments to the Owner. An exception to this rule exists for distributions to the Owner so long as the principal purpose of the distribution is not the recognition of gain that is due to changes in market conditions while the FASIT held the debt instrument. This rule effectively allows an Owner to reduce over-collateralization so long as the reduction is not designed to obtain a character advantage. Absent this rule, in times of falling market interest rates, an Owner could inappropriately generate capital gain and economically offsetting ordinary loss by disposing of distributed appreciated debt instruments while having the FASIT dispose of related hedges. To clarify the application of the distribution rule, the proposed regulations deem a distribution of a debt instrument to be carried out principally to recognize gain if the Owner (or a related person) sells the substituted or distributed debt instrument at a gain within 180 days of the substitution or distribution. In this case, the distribution will be a prohibited transaction subject to the 100-percent tax.

Consequences of FASIT Cessation

Under the FASIT provisions, the Commissioner may consent to the intended cessation of a FASIT and may grant conditional relief in the case of an inadvertent cessation. There are, however, no comprehensive rules describing the consequences of a cessation. The proposed regulations, therefore, detail how a cessation affects the FASIT, the underlying arrangement that made the FASIT election, the Owner, and the regular interest holders. These rules apply unless a cessation is carried out with the Commissioner's consent, in which case the consent document controls.

Under the proposed regulations the Owner is treated as disposing of the FASIT's assets for their fair market value in a prohibited transaction. Gain, if any, on this deemed distribution is subject to the prohibited transactions tax. Any loss is disallowed. The Owner is also treated as satisfying the regular interests for an amount equal to the lesser of the adjusted issue price or fair market value of the regular interests. This deemed satisfaction will result in cancellation of indebtedness income in cases where the aggregate fair market value of the assets is less than the aggregate adjusted issue price of the regular interests. The underlying arrangement is no longer treated as a FASIT and generally is prohibited from making a new FASIT election. In addition, the underlying arrangement is treated as holding the assets of the terminated FASIT and is classified (for example, as a corporation or partnership) under general tax principles. Finally, the regular interest holders are treated as exchanging their FASIT regular interests for new interests in the underlying arrangement. These new interests are classified under general tax principles, and the deemed exchange of the regular interests for the new interests may require the regular interest holders to recognize gain or loss.

Rules Applicable to Owner

Under the FASIT provisions, an Owner generally determines its taxable income by including the gains, losses, income and deductions of the FASIT and by treating the assets and liabilities of the FASIT as its own. In addition, the Owner must also follow special rules concerning the FASIT's tax-exempt income, prohibited transactions and method of accounting for debt instruments. Few comments were received concerning these provisions.

Under the special rule concerning the method of accounting for debt instruments, a FASIT must use the constant yield method in determining all interest, acquisition discount, original issue discount (OID), market discount, and premium deductions or adjustments. To ensure that the Owner uses a constant yield method for all interest and interest-like items, the proposed regulations require the Owner to compute the amount of interest income and premium offset accruing on debt instruments held in a FASIT under the methodology described in § 1.1272-3(c).

One commentator noted that the FASIT provisions speak in terms of determining the Owner's taxable income, and that taxable income, which the Code defines as gross income minus deductions, makes no reference to credits. The proposed regulations, therefore, clarify the extent to which an Owner, in determining its tax, may claim the FASIT's credits. In general, the Owner may claim a credit for taxes paid or deemed paid by the FASIT in the same manner and to the same extent as if the FASIT were an unincorporated branch of the Owner. As discussed below, the allowance of a foreign tax credit is subject to the anti-abuse provisions of this regulation, and other relevant authorities including case law and the potential application of IRS Notice 98-5 (1998-3 I.R.B. 49).

Because the Owner includes the FASIT's tax items in determining its credits and taxable income, the proposed regulations make the Owner (rather than the FASIT) responsible for reporting those items on its Federal income tax return. The Owner is required to attach a separate statement to its income tax return detailing these items. No specific form is required.

Gain Recognition on Property Transferred to a FASIT

1. Background

The FASIT provisions require Owners (or, in some cases, related persons) to include in income gain (but not loss) realized on the transfer of assets to a FASIT. In general, the amount of gain (if any) that must be included is equal to the value of the transferred asset over its adjusted basis in the transferor's hands. In addition, the FASIT provisions require gain (if any) to be recognized on assets the Owner holds outside of the FASIT but which nonetheless support FASIT regular interests. Significant comments were received regarding the gain recognition rule. In particular, comments were received on the method of valuing property, the scope of the support rule, and the need for a gain deferral rule.

2. Related-Person Gain Recognition Rule

The IRS and Treasury have determined that the gain recognition rule of the FASIT provisions could be circumvented when a related person transfers property to a FASIT. Because the FASIT provisions do not require that the related person be a taxable C corporation (or even that the related person be subject to U.S. tax), the intended corporate-level tax on gain could be avoided by having non-corporate or foreign related persons make asset transfers. In this case, the FASIT provisions could be interpreted as allocating gain to the related person and the economically offsetting losses (usually in the form of premium offset) to the Owner. This misallocation of gain, if allowed, would frustrate the purpose of the gain recognition rule.

The IRS and Treasury considered two ways to address this issue in developing these proposed regulations. One approach would have required any contribution from a related party to the FASIT to be taxed as if it were a deemed sale to the Owner followed by a contribution to the FASIT. This rule would conform the treatment of related person contributions with the treatment of contributions from unrelated persons under section 860I(a)(2). This rule would also ensure that gain upon contribution would be allocated to the taxpayer entitled to the subsequently occurring offsetting economic loss, namely, the Owner. A second approach was to develop regulations that would limit related person treatment to taxable, domestic C corporations and ensure that the misallocation of gain (in the related person) and associated loss (in the Owner) would not produce unwarranted tax benefits.

The proposed regulations adopt the first approach. Under the proposed regulations, transactions between a related person and the FASIT are treated as transactions between the related person and the Owner followed by transactions between the Owner and the FASIT. This rule, however, does not apply in all cases. Transfers of publicly traded property by related persons are unlikely to be abusive. The rule in the proposed regulations, therefore, only applies if the related person transfers property not traded on an established securities market. Thus, for example, the rule applies to a transfer of consumer receivables, but not to a transfer of Treasury bills.

3. Determination of Value for Gain Recognition Purposes

a. In general. To determine value for purposes of applying the gain recognition rules, the FASIT provisions divide property into two categories: (1) debt instruments not traded on an established securities market, and (2) all other property. The value of debt instruments not traded on an established securities market is determined by a special statutory rule. The value of all other property (which includes debt instruments that are traded on an established securities market) is fair market value.

Under the special rule, the value of a debt instrument not traded on an established securities market is the sum of the reasonably expected cash flows on the instrument, discounted using semiannual compounding at a rate equal to 120 percent of the applicable federal rate (AFR).

The intent behind the special valuation rule is uncertain. The legislative history of the FASIT provisions indicates the rule was meant to be a simple and mechanical formula that, by its nature, would not produce accurate results in every case. Specifically, the legislative history states that the value of an asset is determined by the special valuation rule even if a different value would be determined by applying a willing buyer/willing seller standard. See H.R. Rept.104-737, 104th Cong. 2d Sess., 327 (1996). At the same time, by applying a fair market value standard to all other assets (including market-traded debt), Congress showed a clear preference for using actual fair market value whenever it can be determined with reasonable accuracy.

Several commentators made suggestions on how to interpret the legislative intent behind the special valuation rule. In general, the commentators were concerned that implementing the rule without modification would in many cases generate tax gains far in excess of economic gains. Because the commentators viewed this overvaluation as a substantial impediment to the use of FASITs, they asked that the proposed regulations narrow as much as possible the debt instruments subject to the special valuation rule.

The proposed regulations attempt to reconcile the legislative intent and the commentators' concerns in a consistent and principled manner. The policy justification for the special valuation rule is strongest where it is difficult, if not impossible, to separate the value of a debt instrument from the value of the Owner's business relationship with the debtor. For example, the value of credit card receivables may be inferred if the receivables are placed in trust and used to create new debt instruments that are sold to the public at a disclosed price. In this case, however, the implied price necessarily includes both the value of the receivables and the value of the transferor's implicit or explicit promise to replace the receivables as they mature. Because there is no objective, easily administrable method for allocating the portion of the price allocable to the receivable (as opposed to the portion allocable to the transferor's ongoing business), the special valuation rule seems appropriate in this context.

By contrast, the policy justification for the special valuation rule is weakest in cases where the fair market value of the debt instrument can be easily established. For example, if a FASIT purchases a pool of non-market-traded securities for cash in a transaction where the FASIT maintains no continuing relationship with the seller, there appears to be no reason to distrust the value as determined by an actual arm's length bargaining.

Consistent with this understanding of the purpose behind the special valuation rule, the proposed regulations take a broad view of what constitutes an established securities market. In addition, the regulations clearly delineate whether property is subject to the special rule and provide a number of exceptions from the special rule.

b. Traded on an established securities market. The proposed regulations define the term traded on an established securities market by reference to § 1.1273-2(f)(2) through (4) of the OID regulations. The proposed regulations also give the Commissioner the power to determine that debt instruments not meeting the standards of the OID regulations are nevertheless traded on an established securities market. Under the cross-reference to the OID regulations, debt is considered traded on an established securities market if (1) it is listed on certain specified securities exchanges or on certain interdealer quotation systems, (2) it is traded on a board of trade or interbank market, or (3) it appears on a quotation medium that provides a reasonable basis to determine fair market value by disseminating either recent price quotations or actual prices of recent sales transactions.

The proposed regulations do not cross-reference § 1.1273-2(f)(5) of the OID regulations. Consequently, debt is not considered traded on an established securities market if it is merely readily quotable within the meaning of § 1.1273-2(f)(5). The IRS and Treasury do not expect this omission to have a significant impact because, under a special exception (the spot purchase rule, discussed below) the proposed regulations value non-publicly traded debt instruments at their cost if a FASIT acquires them in (or soon after) an arm's length cash purchase.

According to one commentator, bank loans and private placement loans, which are typically made to small and medium sized businesses, are readily quotable within the meaning of § 1.1273-5(f)(5) but would not otherwise be considered as traded on an established securities market. The commentator stated there would be commercial interest in securitizing these loans through FASITs but for application of the special valuation rule. Although the proposed regulations do not adopt the readily quotable standard, the IRS and Treasury believe bank and private placement loans will be securitized in transactions qualifying for the spot purchase exception. Nevertheless, comments are requested on whether the readily quotable standard is still necessary.

c. Exceptions for debt not traded on an established securities market. The proposed regulations except from the special valuation rule certain beneficial and stripped interests. Under this exception, a certificate representing beneficial ownership of debt instruments constitutes beneficial ownership of debt instruments traded on an established securities market if either the certificate or all of the underlying debt instruments are traded on an established securities market. Similarly, a stripped bond or stripped coupon represents debt traded on an established securities market, if either the strip or the underlying debt instrument is traded on an established securities market. Because fair market value is easily determined in these circumstances, there appears to be little reason to apply the special valuation rule.

Finally, the proposed regulations provide an exception for certain debt instruments that are contemporaneously purchased and transferred to the FASIT (the spot purchase rule). Under this provision, the value of a debt instrument is its cost to the Owner if four conditions are met: (1) the debt instrument is purchased from an unrelated person in an arm's length transaction, (2) the debt instrument is acquired for cash, (3) the price of the debt instrument is fixed no more than 15 days before the date of the purchase, and (4) the debt instrument is transferred to the FASIT no more than 15 days after the date of the purchase.

d. Debt instruments not traded on an established securities market. As discussed above, the special valuation rule values a debt instrument by discounting the reasonably expected cash flows on the instrument. The proposed regulations require that the determination of reasonably expected cash flows be commercially reasonable. The proposed regulations also permit reasonable assumptions concerning credit risk, early repayments, and loan servicing costs to be taken into account. Additional rules discourage the use of assumptions known to be inaccurate.

One safeguard is a consistency test. Even though a debt instrument may not be traded on an established securities market, a person securitizing the debt instrument may make certain public representations about the debt instrument, such as in a prospectus or an offering memorandum. The consistency test prevents the use of one set of assumptions for tax purposes and the use of another set for different purposes. Specifically, all assumptions used in determining reasonably expected cash flows (for purposes of the FASIT valuation rule) must be no less favorable than the assumptions underlying the representations made to any of the following groups in the prescribed order: investors, rating agencies, or governmental agencies. For example, if one default rate is assumed to value debt instruments in a prospectus, a higher default rate cannot be assumed to value the debt instruments for purposes of the gain recognition provisions. Even if no representations concerning value are made to investors, rating agencies, or governmental agencies, the assumptions made for purposes of the gain recognition provisions must still be consistent with any applicable industry customs and standards. To encourage adherence to the consistency test, the Commissioner may determine reasonably expected cash flows without making any adjustment if the assumption made with respect to that adjustment (for example, assumed credit risks) fails the consistency test or is otherwise unreasonable.

In addition to the consistency test, the proposed regulations place a ceiling on projected loan servicing costs. Specifically, the amount of loan servicing costs projected may not exceed the lesser of (1) the amount the FASIT agrees to pay the Owner (or a related person) for servicing all, or a portion, of the loans held by the FASIT, or (2) the amount a third party would reasonably pay for the servicing of identical loans.

e. Special valuation rule for guarantees. Because a guarantee usually is not a debt instrument, any gain recognized on transferring a guarantee to a FASIT would be determined using the guarantee's fair market value absent a special rule. Nevertheless, if a guarantee relates solely to non-traded debt instruments, the proposed regulations allow taxpayers to value the guarantee and the debt instruments together. Under this rule, the reasonably expected payments on the guarantee are treated as part of the reasonably expected payments on the debt instruments to which the guarantee relates.

4. Property Held Outside a FASIT Supporting FASIT Regular Interests

An Owner (or a person related to the Owner) must recognize gain on any property the Owner or related person holds outside the FASIT that supports the regular interests. In addition, property held by the Owner or related person that supports regular interests is treated as held by the FASIT for all purposes of the FASIT provisions. By treating support property as transferred to and held by a FASIT, the support rules discourage taxpayers from trying to avoid the gain-on-transfer rules and ensure that FASIT income includes the income from all FASIT property.

Commentators asked for a clear and narrow definition of support property. They suggested limiting the support rule to situations in which the arrangement with the regular interest holders indicates that assets held outside the FASIT would have been transferred to the FASIT but for the gain recognition rules. Under this view, support property includes: (1) subordinated interests in debt instruments contributed to the FASIT, (2) property securing an Owner's guarantee, and (3) contribution agreements that allow the FASIT to purchase a debt instrument for an amount significantly below its fair market value. Several commentators argued that unless a narrow view of support is adopted, the support rule threatens to subject to the gain recognition rule all property held by an Owner whenever the Owner guarantees a regular interest or has any kind of continuing relationship with the FASIT.

Consistent with the comments received, the proposed regulations narrowly define support property. Under the proposed regulations, property generally is support property if the Owner (or a related person): (1) Identifies the property as providing security for a regular interest, (2) sets aside the property for transfer to the FASIT under a contribution agreement, or (3) holds an interest in the property that is subordinate to the FASIT's interest in the property. This last situation can arise, for example, if the Owner holds the junior interests in a pool of debt instruments while the FASIT holds the senior interests.

5. Deferral of Gain Recognition

Although gain must ordinarily be recognized as soon as property is transferred, the FASIT provisions authorize regulations under which gain on transferred property is deferred until the transferred property supports regular interests. Several commentators specifically requested a gain deferral system and one explained in detail how a gain deferral system could be applied to a constantly revolving pool of assets.

The proposed regulations do not provide a general gain deferral system. After carefully considering the issues involved, the IRS and Treasury have determined that gain deferral rules must build on rules for accounting for pooled debt instruments. The IRS and Treasury anticipate providing rules for pooled debt instrument in future guidance, and at that time expect to revisit the FASIT gain deferral rules.

Although the proposed regulations do not provide rules for gain deferral generally, rules permitting gain deferral for pre-effective date FASITs have been developed consistent with the requirements of the Act. The IRS and the Treasury request comments on whether and how the gain deferral system for pre-effective date FASITs may be modified to accommodate a general gain deferral system.

Ownership Interests and Consolidated Groups

By statute, to qualify as a FASIT, an arrangement must have one (and only one) ownership interest, and that ownership interest must be held by one (and only one) eligible corporation. Congress, however, anticipated that Treasury would “issue guidance on how the ownership rule would apply to cases in which the entity that owns the FASIT joins in the filing of a consolidated return with other members of the group that wish to hold an ownership interest in the FASIT.” See H.R. Conf. Rep. No. 737, 104th Cong., 2d Sess. 329 (1996).

Commentators urged the IRS and Treasury to issue guidance that would change the statutory rule and permit members of a consolidated group to jointly hold a FASIT ownership interest. In studying the issue, however, the IRS and Treasury became concerned about how such guidance would continue to satisfy those general principles of the consolidated return regulations that preclude the shifting of stock basis, income, or loss. The IRS and Treasury considered different models that would permit members of a consolidated group to jointly hold (or enjoy the benefits of jointly holding) a FASIT ownership interest, but none of these were found to adequately address the government's concerns without adding administrative complexity for both the IRS and taxpayers. Moreover, the IRS and Treasury are not convinced the level of potential attribute shifting should be disregarded or addressed through an anti-abuse rule or would be so minor that disregarding it would be appropriate. Therefore, the proposed regulations do not provide rules permitting members of a consolidated group to jointly hold ownership interests in a FASIT. The IRS and Treasury invite the submission of additional comments that would address these concerns.

Transfers of Ownership Interests

The proposed regulations ignore the transfer of an ownership interest if the transfer is accomplished to impede the assessment or collection of tax. A transfer is accomplished to impede the assessment or collection of tax if the transferor knows, or should know, that the transferee would be unwilling or unable to pay some or all of the tax arising from holding the ownership interest. A safe harbor, incorporated through a cross-reference to comparable rules regarding transfers of REMIC residual interests, is available to Owner-transferors who conduct a reasonable investigation of the transferee's financial condition. As explained under the caption PROPOSED AMENDMENT TO REMIC REGULATIONS in this preamble, the REMIC safe harbor incorporated by the FASIT rules has been modified.

Rules Applicable to Regular Interest Holders

The FASIT provisions treat a regular interest as a debt instrument for all purposes of the Code and require the holder to account for gross income with respect to the regular interest under an accrual method.

Few comments were made with respect to FASIT regular interests. One commentator suggested a rule that would prevent the holder of a debt instrument from recognizing a loss on, or changing the tax consequences of, the debt instrument by transferring it to a FASIT in exchange for an identical or similar FASIT regular interest. No such rule is adopted by the proposed regulations because the IRS and Treasury believe this type of transaction is adequately addressed by the wash sales rules of the Code and the FASIT anti-abuse rule described later. Similarly, the proposed regulations have adopted no special rules concerning the consequences of modifying regular interests, because the IRS and Treasury believe these issues are adequately addressed under existing principles of Federal tax law.

Special Rules

Anti-Abuse Rule

The proposed regulations contain an anti-abuse rule patterned after the anti-abuse rule in the partnership regulations issued under subchapter K. The FASIT anti-abuse rule evaluates transactions against the underlying purpose of the FASIT provisions, which is to promote the spreading of credit risk on debt instruments by facilitating the securitization of debt instruments. If a FASIT is formed or used to achieve a tax result inconsistent with this purpose, the Commissioner may take remedial action, including disregarding the FASIT election, reallocating items of income, deductions and credits, recharacterizing regular interests, and redesignating the holder of the ownership interest. Whether a FASIT is formed or used to achieve a tax result that is inconsistent with the FASIT provisions is a question of fact. In addition to applying the specific anti-abuse rule included in these proposed regulations, the IRS and Treasury will also continue to apply other statutory, administrative, and judicial anti-abuse provisions, such as the judicial doctrines of economic substance and substance over form, to transactions and structures involving FASITs. For example, see the principles of Notice 98-5 (1998-3 I.R.B. 49), regarding foreign tax credits.

Although regular interests in a FASIT may be held in a tiered FASIT structure and treated by each FASIT as permitted assets, the tiering of FASITs may not be used for double or multiple counting of the FASIT gross income or gross assets for other purposes of the Code in a manner that would be inconsistent with the intent of the FASIT provisions. In this regard, the IRS and Treasury consider the recognition of interest expense paid and the corresponding interest income received by the same Owner to be inconsistent with the intent of the provisions. Accordingly, such Owner-created attributes must be disregarded because a taxpayer may not enter into a transaction with itself. For example, the gross income and gross assets from the tiering of FASITs may not be taken into account more than once for purposes of testing whether an Owner is an 80/20 company under section 861, or for purposes of determining the relative domestic and foreign source gross assets of the Owner or the Owner's affiliated group in applying the interest expense allocation rules proposed here under section 864(e).

International Provisions

Prohibition of Foreign FASITS and Segregated Pools Subject to Foreign Tax

It appears that taxpayers may attempt to exploit differences in the characterization of a FASIT or the interests in a FASIT under U.S. law and relevant foreign law to produce inappropriate tax avoidance (including by producing a non-economic allocation of foreign taxes to the holder of the FASIT ownership interest). To minimize this possibility, the proposed regulations provide that a foreign entity (including but not limited to a foreign corporation or a foreign partnership) may not be a qualified arrangement. In addition, a qualified arrangement may not be a domestic entity or a segregated pool of identified assets any of the income of which is subject to tax on a net basis by a foreign country. The IRS and Treasury intend that the imposition of foreign tax on a net basis with respect to the assets and liabilities of a FASIT will disqualify a FASIT election without regard to whether the segregated pool of assets is actually held through a U.S. or foreign office or fixed place of business. In addition, a preexisting qualified FASIT may cease to be a FASIT prospectively by being subjected to foreign net taxation for the first time in a later year as a result of newly conducted foreign activities. It is not necessary that actual foreign tax be imposed for an arrangement to be considered subject to foreign net taxation.

The IRS and Treasury request comments regarding whether there may be circumstances in which legitimate (non-tax) business reasons justify allowing a FASIT election to be made by a foreign entity, or an entity the income of which is subject to net foreign taxation, or on behalf of a segregated pool which may be subject to net foreign taxation.

Prohibition on Foreign FASITs and Segregated Pools Subject to Foreign Tax

The IRS and Treasury are also concerned that taxpayers may attempt to use FASITs to produce non-economic allocations of foreign withholding taxes to the holder of the FASIT ownership interest. The IRS and Treasury believe that such transactions may be facilitated by the ease with which an Owner can acquire publicly-traded debt that is subject to foreign withholding tax. In addition, prohibiting a FASIT from holding publicly-traded debt subject to a foreign withholding tax should not unduly interfere with legitimate securitizations of debt held by an Owner. Accordingly, the proposed regulations provide that the definition of permitted debt instruments does not include debt instruments traded on an established securities market if such debt instruments are subject to foreign withholding tax. The IRS and Treasury request comments concerning whether the scope of this rule is adequate to address potentially abusive transactions and whether legitimate (non-tax) business reasons may justify the use of a FASIT to hold foreign debt that is traded on an established securities market and is subject to a foreign withholding tax.

Avoidance of U.S. Withholding Tax

The IRS and Treasury are also concerned that FASITs may be used by foreign resident taxpayers to avoid U.S. withholding taxes that would otherwise be imposed on direct cross-border financing to a foreign person's U.S. subsidiary. In particular, the IRS and Treasury are aware that foreign taxpayers may attempt to use FASITs to convert interest that would be disqualified from the portfolio interest exemption under sections 871(h)(3), 881(c)(3)(B), and 881(c)(3)(C) (concerning interest paid to a 10 percent shareholder and interest paid to a controlled foreign corporation from a related person) into interest that qualifies as portfolio interest. To prevent such avoidance, the proposed regulations provide that interest paid or accrued to a foreign holder of a FASIT regular interest will not qualify as portfolio interest under sections 871(h)(3) and 881(c)(3) to the extent that the FASIT receives or accrues interest from an obligor who is a U.S. resident taxpayer (the related obligor) if (1) the foreign holder is a 10 percent shareholder (within the meaning of Section 871(h)(3)) of the related obligor or (2) the foreign holder is a controlled foreign corporation and the related obligor is a related person (within the meaning of section 864(d)(4)) with respect to the foreign holder. For these purposes, the related obligor is defined as a conduit debtor who is treated as paying interest directly to the 10 percent shareholder or the controlled foreign corporation for purposes of sections 871, 881, 1441 and 1442. This rule characterizes all interest of the foreign regular interest holder as non-portfolio interest if the FASIT receives or accrues an equal or greater amount of interest from the related obligor.

Further, the IRS and Treasury request comments concerning whether FASIT regular interests, REMIC regular interests, and pass through certificates should be treated in a consistent manner for purposes of applying U.S. withholding tax rules.

The IRS and Treasury intend to issue regulations that will provide that the FASIT and its Owner are withholding agents in respect of payments made to foreign regular interest holders.

The IRS and Treasury solicit comments with respect to circumstances in which the FASIT and its Owner may be unaware of a possible relationship between foreign regular interest holders and the related obligors of the debt instruments held by the FASIT or other circumstances under which it would be inappropriate to treat payments to a regular interest holder as payments directly from a conduit debtor. It is anticipated that these regulations will provide that the FASIT and its Owner will not be responsible for withholding amounts paid to the foreign regular interest holders in the above circumstances unless the FASIT or its Owner knows, or has reason to know, that the foreign regular interest holder is a 10 percent shareholder of the related obligor or is a controlled foreign corporation considered to be receiving interest from a related person. It is expected that these regulations will further provide that the FASIT and its Owner shall be presumed to know that these circumstances exist if the foreign regular interest holder owns 10 percent or more of the total value of the FASIT's regular interests and the debt of the related obligor accounts for 10 percent or more of the total value of the FASIT's assets.

Earnings Stripping and Original Issue Discount

The IRS and Treasury are also aware that regular interests in FASITs may be used by foreign residents to avoid other consequences that might apply to cross-border related-party payments. The IRS and Treasury are concerned that taxpayers may attempt to use FASITs to avoid the deferrals on deductibility imposed by sections 163(e)(3) on OID owing to related foreign persons and 163(j) on net interest expense that is otherwise treated as disqualified under the earnings stripping rules.

Similar to the rules adopted for portfolio indebtedness purposes, the proposed regulations treat a U.S. resident taxpayer who is an obligor to a FASIT as a conduit debtor to the extent a related person (within the meaning of section 267(b) or 707(b)(1)) who would not be subject to tax on a direct payment by the U.S. obligor receives interest with respect to a regular interest in the FASIT. In such circumstances, the earnings stripping provisions will apply to treat interest paid by a U.S. corporation or a U.S. trade or business of a foreign corporation on an obligation held by a FASIT as disqualified interest for purposes of section 163(j). Similarly, the conduit debtor rule also operates to treat OID accrued to a FASIT by a domestic party as deferred to the extent a related foreign person (as defined in section 163(e)(3)(B)) receives interest with respect to a regular interest of the FASIT. These rules apply to payments and accruals made during the same period the regular interest in the FASIT is held by the 10 percent shareholder or foreign related party.

No Correlative Adjustments to FASIT

The FASIT and its Owner are not entitled to any correlative adjustments for amounts that are treated as directly paid by a conduit debtor and treated as directly received by or accrued to a related party. Accordingly, all interest paid or accrued by the conduit debtor to the FASIT must be taken into account by the Owner in determining its own taxable income. This treatment is consistent with Treasury's general approach, already adopted in conduit financing regulations, to preventing withholding tax avoidance. TD 8611, 1995-2 C.B. 286, 293.

Interest Expense Allocation

For purposes of applying the interest expense allocation rules to the Owner under section 864(e) and the regulations thereunder, new proposed regulations provide that all interest expense from all FASITs that is treated as incurred by any Owner or by any other Owner that is a member of the same affiliated group of which the Owner is a member is directly allocated solely to all income from all FASITs of such Owners. The directly allocated interest expense is treated as directly related to all activities and assets of all the Owner's FASITs and is apportioned between domestic and foreign source FASIT gross income by applying the general asset method to the FASIT's assets. The proposed interest allocation rules also extend the existing asset adjustment rules under the asset method in § 1.861-9T(g), which reduce assets to reflect the principal amount of indebtedness outstanding relating to the interest which is directly allocated. The rules of § 1.861-10T(d)(2) are also made applicable. In addition, the new proposed interest allocation rules are the exclusive method for the direct allocation of FASIT interest expense. The IRS and Treasury are not aware of any situations in which the direct allocation rules of the existing temporary regulations would apply to any items of FASIT income and interest expense. Comments are solicited in this regard.

The rules apply to interest expense with respect to any FASIT as of that FASIT's startup day and throughout the entire period that the arrangement continues to qualify as a FASIT. The rules provide the Commissioner with discretion to continue to directly allocate interest expense with respect to a ceased FASIT to FASIT income if the Commissioner determines that a principle purpose for terminating the FASIT was to affect the interest allocation.

The IRS and Treasury believe that directly allocating FASIT interest expense solely to FASIT gross income is an administrable and appropriate way to limit distortions (favorable or unfavorable as the case may be) to a taxpayer's overall allocation of interest expense for foreign tax credit purposes. It is recognized, however, that the new proposed direct allocation rules may enable certain interest expense allocation planning that may create distortions that would not occur under existing interest allocation rules. To address these concerns, the IRS and Treasury are considering whether to adopt rules in final regulations that limit the extent to which the direct allocation rules may apply, including rules regarding the amount of variance between the direct allocation and combined asset allocation rules that is appropriate. Comments are solicited on this issue.

Pre-Effective Date FASITs

Section 1691(e) of the Small Business Job Protection Act of 1996 (the Act) provides special transition rules for securitization entities in existence on August 31, 1997. Under these rules, the Owner of a pre-effective date FASIT may defer the recognition of FASIT gain on assets attributable to pre-FASIT interests. For purposes of this rule, a pre-effective date FASIT is a FASIT the underlying arrangement of which was in existence on August 31, 1997. A pre-FASIT interest is an interest in the underlying arrangement that was outstanding on the FASIT startup date and that is considered debt under general tax principles.

The proposed regulations provide a safe-harbor method of accounting that allows the separation of FASIT gain attributable to pre-FASIT interests, and other FASIT gain. Basically, the safe-harbor method has three steps. Under the first step, the Owner groups the assets of the FASIT into pools. To ensure that each pool can be marked to market using a valuation methodology appropriate for its constituent assets, the proposed regulations provide that no pool may contain assets of more than one of the following three types: (1) assets that are valued under the special valuation rule and that have FASIT gain on the first day they are held by the FASIT, (2) assets that are valued under general fair market value principles and that have FASIT gain on the first day they are held by the FASIT, and (3) assets that do not have FASIT gain on the first day they are held by the FASIT.

Under the second step, the Owner periodically computes for each pool the difference between the income determined under a mark-to-market system (using the appropriate FASIT valuation methodology) and the income determined under an accrual system. This difference is referred to as FASIT gain (or loss) and is essentially a measure of the gain (or loss) from the pool that is attributable to the operation of the FASIT gain recognition rules. These rules require gain to be determined at the pool level when assets are contributed to a FASIT, and implicitly allow this gain to be reversed out (as deductions in the nature of premium offset) as the assets in the pool mature. In periods in which net contributions are made to the pool, the calculation generally will produce FASIT gain. In periods in which the pool decreases in size or duration, the calculation generally will produce FASIT loss. This FASIT loss is, in effect, a recapture of previously determined FASIT gain. Over the entire life of a pool, the aggregate FASIT gain (or loss) will be zero; the FASIT valuation rules do not create lifetime net income.

Under the third step, the Owner determines the proper amount of FASIT gain (or loss) to recognize during the current period. To determine this amount, the Owner first calculates the total amount of FASIT gain as of the last day of the current period. The Owner then reduces this amount to exclude the percentage of the FASIT gain that is attributable to pre-FASIT interests outstanding on the last day of the period. This reduced amount represents the cumulative amount of FASIT gain the Owner should recognize by the end of the current period. Finally, to adjust for amounts recognized in previous periods, the Owner subtracts from this amount the cumulative amount of FASIT gain that the Owner had recognized at the end of the previous period. The difference is the amount of FASIT gain (or loss) to be recognized in the current period.

Owners of pre-effective date FASITs that presently use a gain deferral methodology that differs from the safe harbor method described above may adopt the safe-harbor method. The IRS and Treasury request comments on whether guidance is needed on how this change of method may be accomplished.

Proposed Amendment to REMIC Regulations

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 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 residual interest is presumed not to have a wrongful purpose if two requirements are satisfied. First, the transferor must conduct a reasonable investigation of the transferee's financial condition. Second, the transferor must secure 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 IRS and Treasury are concerned that some transferors of 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. The proposed regulations, therefore, would clarify the safe harbor. The proposal explains 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. No inference is intended regarding whether any existing transactions satisfy the substantive requirements of this safe harbor before the clarification made by this amendment.

Proposed Effective Date

In general, the proposed regulations including the proposed amendments to the interest expense allocation regulations are proposed to apply on the date final regulations are filed with the Federal Register. The portion of the proposed regulations containing the anti-abuse rule and the portion of the proposed regulations allowing the deferral of gain on assets held by a pre-effective date FASIT are proposed to apply on February 4, 2000. The proposed amendment to the REMIC regulations is proposed to apply to all transfers occurring after the date final regulations concerning the amendment are published in the Federal Register.

Special Analyses

It is hereby certified that these proposed 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 FASIT ownership 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. Pursuant to section 7805(f) of the Internal Revenue Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for May 15, 2000, beginning at 10 a.m. in Room 2615 of the Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section of this preamble. The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by April 24, 2000. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is David L. Meyer, Office of Assistant Chief Counsel (Financial Institutions and Products), IRS. 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

Proposed Amendments to the Regulations

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

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry for 1.861-10(e) and adding entries in numerical order to read as follows:

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

Section 1.860H-1 also issued under 26 U.S.C. 860L(h).

Section 1.860H-2 also issued under 26 U.S.C. 860L(h).

Section 1.860H-3 also issued under 26 U.S.C. 860L(h) and 860L(f).

Section 1.860H-4 also issued under 26 U.S.C. 860L(h).

Section 1.860H-5 also issued under 26 U.S.C. 860L(h) and 7701(l).

Section 1.860I-1 also issued under 26 U.S.C. 860L(h) and 860I(c).

Section 1.860I-2 also issued under 26 U.S.C. 860L(h).

Section 1.860J-1 also issued under 26 U.S.C. 860L(h).

Section 1.860K-1 also issued under 26 U.S.C. 860L(h).

Section 1.860L-1 also issued under 26 U.S.C. 860L(h).

Section 1.860L-2 also issued under 26 U.S.C. 860L(h).

Section 1.860L-3 also issued under 26 U.S.C. 860L(h).

Section 1.860L-4 also issued under 26 U.S.C. 860L(h). * * *

Section 1.861-9 also issued under 26 U.S.C. 864(e)(7).

Section 1.861-10 also issued under 26 U.S.C 863(a), 26 U.S.C. 864(e)(7), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f). * * *

Par. 2. Section 1.860E-1 is amended by:

1. Revising paragraph (c)(4).

2. Adding paragraphs (c)(5) and (c)(6).

The addition and revision read as follows: