IRS cracks down on self-amortizing investments in conduit financing entities.

In Notice 97-21, the IRS noted that certain persons are engaging in multiple-party financing transactions designed to allow a person (the sponsor) to avoid tax on substantial amounts of income (or to shelter substantial amounts of other income), by using a conduit entity whose income tax treatment artificially allocates the conduit's income to participants not subject to Federal income tax.

Example: A corporate sponsor forms a real estate investment trust or a foreign corporation (the Company). The Company issues two classes of stock. The corporate sponsor holds substantially all of the Company's common stock. The other class (the fast-pay preferred stock) is held by persons not subject to Federal income tax (exempt participants). The fast-pay preferred stock has limited voting rights and provides for preferred "dividends" equal to 13% of the stock's issue price each year for 10 years.

The Company holds income-producing assets (such as one or more mortgage loans) that are the obligations of, or guaranteed by, the corporate sponsor or guaranteed by a Federal agency. At all times during the first 10 years after the fast-pay preferred stock is issued, the Company must invest in assets that will produce income and cash flows at least equal to 101% of the dividends payable on the fast-pay preferred. During the first 10 years, the Company also may make distributions on its common stock; however, it cannot distribute more than 105% of its income in any year. Accordingly, it is not permitted to make any distributions representing a meaningful return of initial investment to the common stock holders during the first 10 years.

In year 11 and thereafter, the fast-pay preferred stock provides for distributions each year of 1% of its original issue price. As a result, after the first 10 years, the fast-pay preferred stock's fair market value is substantially less than its cost to the exempt participants.

Beginning in year 11, the Company may be merged into another corporation without the exempt participants' approval, provided that they receive a formula payment equal to the present value of the annual 1% dividend payments on the fast-pay preferred stock (using a 10% discount rate). Otherwise, the fast-pay preferred stock cannot be called by the Company.

As illustrated by this example, the fast-pay preferred stock performs economically much like a 10-year, self-amortizing debt instrument. That is, the fast-pay preferred stock payments reflect, in part, recoveries of the exempt participants' original investment and, in part, a market yield on that investment's unamortized portion. The fast-pay preferred stock's economic self-amortization is conceptually inconsistent with characterizing the full amount of each payment as a "dividend" (and, thus, as income on an investment).

At the end of 10 years, the Company's obligation to make fast-pay preferred stock distributions will have virtually ceased, and substantially all of the Company's net value will be represented by its common stock. Because only the Company's current income will have been distributed during the first 10 years, the value of the Company's assets is unlikely to have declined significantly. Accordingly, the sponsor's investment in the Company economically performs like a zero-coupon investment--substantially increasing in value as the exempt participants' interest in the Company declines. If the Company makes the formula payment to the exempt participants after the initial 10 years, the Company may be merged into, or consolidated with, a corporate sponsor or its affiliate. In that event, the corporate sponsor expects to receive substantially all of the Company's assets (with the Company's high basis) without recognizing any gain.

Consequently, in the example, the corporate sponsor's expectation in investing in the Company is that it will realize a predictable economic benefit at the end of the 10 years without ever incurring any tax liability for that benefit. Alternatively, if the Company's principal asset is a debt instrument or other obligation issued by the sponsor, the sponsor could be viewed as attempting to use deductions from that debt instrument or obligation to shelter income, without ever having to recognize its share of the income corresponding to those deductions. These expectations result from the parties' dividend treatment of the full amount of the payments to the exempt participants. This treatment causes substantially all of the Company's income to be allocated to the exempt participants, even though a significant portion of it inures economically to the sponsor.

Alternative tax-avoidance structures may involve the use of other conduit entities whose income generally is subject to U.S. income tax only at the shareholder level, where the amount of the tax depends on the receipt or non-receipt by the shareholder of earnings and profits (E&P) from the conduit entity. The terms of the stock issued by the conduit entity also may vary and the stock may be subject to buy or sell options.

Proper Characterization of the Transactions

Under Sec. 7701(1), the IRS may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among two or more of the parties in order to prevent tax avoidance. The Service expects to issue regulations recharacterizing any transaction (for example, the transaction described above) in which:

--a conduit entity is interposed between two or more parties;

--an investment in the conduit is economically partially or fully self-amortizing, taking into account all relevant factors, including options to buy or sell (i.e., the value of the investor's interest in the conduit is expected to decrease over time as payments are received); and

--payments by the conduit that represent a recovery of the investor's investment are treated by the conduit as a distribution of E&P or otherwise as reducing the conduit's or any other taxpayer's taxable income.

It is expected that, under these regulations, the sponsor will be treated as having engaged in a transaction directly with the other parties to the debt instruments, leases or other assets held by the conduit, and the holders of the self-amortizing interests in the conduit will be treated either as having engaged in the transaction directly with the other parties or in an income "stripping" transaction with the sponsor.

If the sponsor is the issuer of a debt instrument held by the conduit, the sponsor may be treated as having issued one or more instruments directly to the holders of the self-amortizing interests in the conduit. In that event, the sponsor's obligation under any asset held by the conduit will be ignored in determining the sponsor's taxable income.

These Sec. 7701(1) regulations apply to tax years ending after Feb. 26,1997. Thus, all amounts accrued or paid on or after the first day of the first tax year ending after Feb. 26, 1997 will be subject to those regulations, regardless of when a particular share of stock or a particular debt instrument was issued or acquired.

To the extent a payment or accrual under a conduit financing transaction is not subject to these regulations, the IRS may determine under existing tax principles, depending on the facts of the particular case, that the transaction does not produce the results intended by the participants.

Comments on Notice 97-21 may be submitted to:

CC:DOM:CORP:R(OGI-103642-97)

Room 5226

Internal Revenue Service

POB 7604

Ben Franklin Station

Washington,D.C. 20044

The notice does not have any deadline for submitting these comments, which will be available for public inspection.