The IRS has proposed new regulations that would amend the definition of a “registration-required obligation” to broaden the scope of the types of arrangements that constitute pass-through certificates that generate portfolio interest that is not subject to US federal withholding tax when received by a foreign investor.
On September 15, 2017, the Internal Revenue Service (IRS) released new proposed regulations amending the definition of a “registration-required obligation” and clarifying the types of arrangements that qualify as “pass-through certificates.” Comments on the proposed regulations are due by December 18, 2017.
Interest that qualifies as “portfolio interest” for US federal income tax purposes is not subject to US federal or withholding tax when received by a foreign investor unless it is otherwise connected to a US trade or business of that foreign investor. For interest to qualify as “portfolio interest” it must be received from a debt obligation treated as in registered form (in addition to meeting certain other requirements). In general, an obligation is in registered form if it can only be transferred through a book-entry system maintained by the issuer or its agent (or in the case of a physical security, the issuer has required involvement in any transfer). Interest received from a pass-through certificate that is in registered form is treated as eligible for “portfolio interest” treatment for US federal income tax purposes regardless of whether the loans or other assets held by the entity issuing the pass-through certificate qualify for that treatment.
Under the current regulations, a pass-through certificate must be issued by a grantor trust (or similar pooled fund or pooled trust that qualifies as a grantor trust) that holds a “pool” of loans. The IRS has issued several private letter rulings (which can only be relied upon by the taxpayer who received them) to the effect that a pooled fund does not have to qualify as a grantor trust if it instead qualifies as a partnership or disregarded entity for US federal income tax purposes (i.e., an entity not treated as a corporation for US federal income tax purposes that is wholly owned by a single beneficial owner). Given the ambiguous language in the current regulations and the unfavorable tax consequences of failing the registered form requirements, if portfolio interest treatment is desired, it is prudent to either create an entity that qualifies as a grantor trust or seek and receive a private letter ruling from the IRS.
The proposed regulations would broaden the definition of “eligible pass-through certificates” to provide that a pass-through certificate may be issued by a grantor trust or a similar fund, and specify that a “similar fund” includes entities that are treated as partnerships or disregarded entities for US federal tax purposes. Generally, for an entity to qualify as a grantor trust within the meaning of the Internal Revenue Code of 1986, as amended, it can only acquire new assets for up to 90 days beginning on the date it was organized. This limitation does not apply to entities that qualify as partnerships or disregarded entities for US federal income tax purposes. In addition, the proposed regulations would eliminate the requirement that the fund hold a “pool” of loans and replace it with a requirement that the fund primarily hold debt instruments. Thus, a fund would be permitted to hold only a single loan so long as that loan were its primary asset.
The proposed regulations do not explain what it means to “primarily” hold debt instruments. Therefore, if the final regulations do not provide further clarity, structures where a significant proportion of a fund’s assets consist of swaps or other assets that are not debt instruments (e.g., swaps, property received on foreclosure, or the short-term investment of cash in eligible investments such as mutual fund shares) may raise questions. In these circumstances, it still may be advisable to use a “tiered” structure where one entity (the “upper-tier entity”) holds all of the equity of another entity (the “lower-tier entity”) along with the other assets that are not debt instruments.
The proposed regulations would apply the new definition of “pass-through certificate” only to pass-through certificates and participation interests issued after the final regulations are adopted. If the proposed regulations are adopted as proposed, the current rules would continue to apply to pass-through certificates issued on or before the date when the new regulations are finalized. Therefore, securitization and other transactions should continue to use pass-through certificates issued by grantor trusts that hold a “pool” of loans until the new regulations are finalized.
The proposed regulations address the tax treatment of payments of interest to holders of pass-through certificates, but would not affect the tax treatment of payments of interest made to the issuer of the pass-through certificates, including payments on the loans underlying the certificates. Currently, unless the issuing entity is treated as a United States person for US federal income tax purposes, payments to that entity generally must be received by a US financial institution in order to avoid being subject to US withholding tax. Structuring a disregarded entity that is wholly owned by a foreign person as a state law trust (rather than a limited liability company) allows payments on the underlying loans to be received by a US financial institution as trustee on behalf of that entity. The proposed regulations would not change this analysis.
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Zuza G. Savoff
 Guidance on the Definition of Registered Form, 82 Fed. Reg. 43,720 (Sept. 19, 2017).
 The proposed regulations also would conform the existing rules on when dematerialized bonds or immobilized bonds will be treated as being in registered form to the IRS public guidance issued on this topic since the existing regulations were originally adopted.
 A physical security, not transferrable through a book-entry system, will also be treated as in registered form if transfer of such security may only be effected by surrender of the old instrument and either the reissuance by the issuer of the old instrument to the new holder or the issuance by the issuer of the new instrument to the new holder.
 A “similar fund,” however, does not include a business entity classified as a corporation for US federal income tax purposes.