US IRS issues proposed regulations. and registered form rules. Executive summary. Detailed discussion. EY Global Tax Alert Library.

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1 25 September 2017 Global Tax Alert US IRS issues proposed regulations on registrationrequired obligations and registered form rules EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary In REG , the US Internal Revenue Service (IRS) has issued proposed regulations on registration-required obligations and rules for determining whether those obligations are considered issued in registered form. Specifically, the proposed regulations would: (1) update the definition of when an obligation is registration required, (2) update the definitions of registered form to respond to changes in market practices and to reflect statutory amendments, and (3) provide increased flexibility for wrapper structures used to convert obligations into registered form so that they can qualify for the portfolio interest exemption from withholding tax. Detailed discussion Background Requirements for obligations to be in registered form Various sections of the Internal Revenue Code impose tax consequences on both issuers and holders of registration-required obligations that are not issued in registered form. Section 163(f) denies the issuer an interest deduction. Section 4701 imposes an excise tax on the issuer. Section 165(j) denies the holder a deduction for losses. Section 1287 denies holders capital gain treatment for gains on sale. Other sanctions apply under Sections 312(m) and 149(a).

2 2 Global Tax Alert In addition, the portfolio interest exception under Sections 871(h) and 881(c) for US-source interest received by a nonresident alien or foreign corporation applies only if, among other things, the underlying obligation is in registered form. This requirement for portfolio interest treatment applies even if the underlying obligation is not registration-required. Of a type offered to the public In general, under Section 163(f)(2), a registration-required obligation means any obligation other than one that: (i) is issued by a natural person, (ii) is not of a type offered to the public, or (iii) has an original term to maturity of not more than one year. Under Treas. Reg. Section 5f.163-1(b)(2), the determination as to whether an obligation is of a type offered to the public is based on whether similar obligations are in fact publicly offered or traded. Registered form Generally, an obligation is in registered form if it is not possible for a holder to transfer its rights vis-à-vis the issuer to a third party, such that the third party acquires rights directly against the issuer, without the issuer or an agent knowing about it. Obligations payable to bearer or to order are not in registered form. Obligations that are publicly offered or intended to be readily tradable in the secondary market most likely will be in registered form. Such obligations are held through a book-entry system operated by a clearing organization (e.g., Depository Trust Company, Clearstream and Euroclear) and its participating banks and brokers identify the holders of interests in the obligation as required under Treas. Reg. Section (c)(2). Other obligations can be drafted to be in registered form. More specifically, Treas. Reg. Section 5f.103-1(c) provides guidance on when an obligation is in registered form. Since its issuance, however, market practices have changed with respect to how interests in obligations are recorded and transferred. In some markets, securities are evidenced by a physical (paper) certificate ostensibly payable to bearer, but that in practice can only be held and transferred through an electronic book-entry system. The fact that the physical certificate is payable to bearer is meaningless in practice, because the physical certificate can be accessed only in extraordinary events. Also, many obligations now trade in fully dematerialized form, meaning that the obligation is not represented by a physical certificate at all. Instead, the obligation can only be held and transferred through an electronic book-entry system. Notices and provided additional guidance on the definition of registered form and dematerialized book entry systems. Notice further announced the IRS s intention to issue regulations consistent with its guidance. Wrappers and pass-through certificates Certain obligations, such as residential mortgage loans and student loans, generally are not issued in registered form. They are not registration-required because they are mostly issued by individuals and in many cases are clearly not of a type offered to the public. Foreign investors in such obligations, however, need to have them in registered form to obtain the portfolio interest exemption from withholding tax. Temp. Reg. Section T and Treas. Reg. Section generally provided that, if a grantor trust (sometimes referred to as a wrapper ) held mortgage loans, then: (1) an interest in the grantor trust (the passthrough certificate) that is itself in registered form satisfied the registration-required rules; and (2) interest payments made on the pass-through certificate from the underlying mortgage loans could qualify for portfolio interest treatment. Unfortunately, the regulations were unclear as to whether structures other than grantor trusts could qualify. To constitute a grantor trust, a trust holding investments must qualify as a fixed investment trust, which can create inflexibility in structuring the investment. As a result, the IRS received comments asking for greater clarity on the types of arrangements that qualify as pass-through certificates. Specifically, commenters requested amendments to the definition of a pass-through certificate to clarify that the issuer of a pass-through certificate may be either a grantor trust or another type of entity (such as a partnership or a disregarded entity), as long as the obligations in the pool are held through an arrangement that meets the requirements to be in registered form. Participation interests If a registered holder of an obligation in registered form sells a participation interest in the obligation to a third party, the third party might be viewed as only having rights against the registered holder/participation interest creator rather than directly against the issuer. It was unclear whether the participation itself had to be in registered form to qualify for portfolio interest treatment.

3 Global Tax Alert 3 Proposed regulations Registration-required obligation Under the proposed regulations, an obligation would be of a type offered to the public if it is viewed as traded on an established market under Treas. Reg. Section (f) (not taking into account the exception for small debt issues in Treas. Reg. Section (f)(6)). Roughly speaking, this means that an obligation would be of a type offered to the public if it is possible to obtain price quotes for the obligation from dealers and brokers (including indicative quotes). Registered form The proposed regulations state that an obligation is considered to be in registered form if it is transferable through a book entry system including a dematerialized book entry system that is maintained by the issuer of the obligation, an agent of the issuer, or a clearing organization. A clearing organization is defined as an entity that is in the business of holding obligations for, or reflecting the ownership interests of, its members and transferring obligations among members accounts without the necessity of physical delivery of the obligation. In addition, the proposed regulations state that an obligation represented by a physical certificate in bearer form will be considered in registered form if the physical certificate is effectively immobilized. In general, a physical certificate would be effectively immobilized if issued to and held by a clearing organization under arrangements that: (1) prohibit the transfer of the physical certificate except to a successor clearing organization, and (2) permit transfers of ownership interests in the underlying obligation only through a book entry system. The proposed regulations would eliminate the additional requirement in Notice that the successor clearing organization hold the certificate subject to the same terms as the predecessor. In general, an obligation is in bearer form if it can be converted into bearer form, even if it has not yet been converted. Under the proposed regulations, however, holders of obligations may have the right to obtain physical certificates evidencing an obligation in bearer form without causing the obligation to be treated as in bearer form until it is actually issued in bearer form when: (1) a termination of the clearing organization s business without a successor, or (2) the issuance of physical securities at the issuer s request upon a change in tax law that would be adverse to the issuer but for the issuance of physical securities in bearer form. The proposed regulations do not include the Notice default exception, which would have permitted a holder the right to obtain a physical bearer certificate upon an issuer event of default. Wrappers and pass-through certificates The proposed regulations would amend the definition of pass-through certificate to address requests for additional guidance regarding entities other than grantor trusts that may issue pass-through certificates for a pool of debt instruments that varies over time. Specifically, the proposed regulations state that a pass-through certificate may be issued by a grantor trust or a similar fund. A similar fund includes: (1) a partnership or an entity disregarded as a separate entity from its owner for federal tax purposes; and (2) a fund with the power to vary the assets it holds or the sequence of payments made to holders. The proposed regulations would specifically exclude corporations for these purposes. The proposed regulations would allow this mechanism to be used for any type of debt instrument. The IRS also determined that an arrangement satisfying the registration-required obligation and registered form rules should be treated the same as a pass-through certificate even if it is with respect to only one underlying obligation or the arrangement is treated as co-ownership of one or more obligations. Accordingly, the proposed regulations would eliminate the requirement that a fund hold a pool of loans and instead require the fund to hold primarily debt instruments. Participation interests The proposed regulations provide that, even if an obligation is in registered form, interest received with respect to a participation interest in the obligation could not qualify for portfolio interest treatment unless the participation interest itself is in registered form. Applicability dates To the extent that the proposed regulations were presaged in Notice , they generally apply to obligations issued after 18 March Taxpayers may, however, continue to apply the rules in Section 3 of Notice (including the default exception) for obligations issued before the date on which the proposed regulations are adopted as final regulations.

4 4 Global Tax Alert The rules in these proposed regulations related to passthrough certificates, participation interests, REMIC regular interests and obligations not of a type offered to the public were not described in Notice Therefore, the special rules for those types of obligations in these proposed regulations will generally apply only to obligations issued after publication of final regulations. Implications The revised definition of when an obligation is registrationrequired is clearer than the earlier regulations. In that sense, it would be a welcome change. The revised definition of registered form is consistent with the earlier guidance in the Notices, although it does not provide as much flexibility as commentators had desired for obligations that must be converted into bearer form for emergency reasons not related to US tax. The new rules on wrappers and pass-through certificates, if issued in final form, will provide more certainty to issuers, and the ability to use partnerships and disregarded entities instead of pass-through certificates will greatly simplify transactions and provide added flexibility. The rules on participation interests may be viewed as unwelcome, but are not inconsistent with the spirit of the rules for registered form obligations. The proposed regulations did not weigh in on an additional issue that can create uncertainty. Specifically, it remains unclear whether the definition of registered form for purposes of Section 165(g)(2)(C) (dealing with worthless securities) mirrors the definitions for registration required obligations and the portfolio interests rules. Because an interest in registered form issued by a corporation is not eligible for bad debt treatment under Section 166 (as a result of qualifying as a security under Section 165(g)(2)(C)), one must consider which debts should be in registered form. As a result of the greater certainty around the definition of registration required obligation, when the proposed regulations are finalized, taxpayers may want to consider explicitly requiring all intercompany debt issued by corporations to be in bearer form to ensure that all such debt will be eligible for bad debt treatment.

5 Global Tax Alert 5 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services Lilo Hester, Washington, DC lilo.hester@ey.com Benjamin Orenstein, New York benjamin.orenstein@ey.com Ernst & Young LLP, International Tax Services Capital Markets Matthew Stevens, Washington, DC matthew.stevens@ey.com Michael Yaghmour, Washington, DC michael.yaghmour@ey.com Ernst & Young LLP, Financial Services Matthew S. Blum, Boston matt.blum@ey.com Tara Ferris, New York tara.ferris@ey.com International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit ITS Markets Leader, Americas, Stephen O Neil, New York Ernst & Young LLP, National Director of ITS Technical Services, Jose Murillo, Washington ITS Regional Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Chris J Housman, New York Central Mark Mukhtar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Houston West Beth Carr, San Jose, CA Canada Ernst & Young LLP (Canada) Albert Anelli, Montreal

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