Changes to Tax Guidance Issued in Response to the Financial Market Turmoil

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1 Changes to Tax Guidance Issued in Response to the Financial Market Turmoil Changes to Tax Guidance Provided in Response to the Market Turmoil, Including Extensions of Expiring Provisions SUMMARY In response to turmoil in the financial markets in 2008, the Internal Revenue Service and the Treasury Department have issued a number of notices and other guidance on the rules that apply to loans from foreign subsidiaries, net operating losses and other carryforwards, auction rate securities, tax exempt bonds, dividends paid by real estate investment trusts ( REITs ) and regulated investment companies ( RICs ), and other matters. Congress also responded with amendments to the Code. A number of these provisions were scheduled to expire by their terms, but have now been extended beyond their original sunset dates. Some provisions have also been amended in substantive respects. Below is a summary of the provisions that have been extended or amended, as of the end of SECTION 956 INVESTMENTS IN UNITED STATES PROPERTY UPDATE: On December 28, 2009 the IRS issued a Notice which extends for another year the rule lengthening the term of short-term lending from a controlled foreign corporation (a CFC ) that is permissible without resulting in inclusion of the CFC s foreign earnings in its U.S. shareholder s income New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 from 30 to 60 days, and also extends the period to which the modified definition of readily marketable may be applied. 1 Period for Short Term Lending An investment by a CFC in certain United States property is treated as a distribution of earnings to its United States shareholders, notwithstanding that there is no actual distribution. United States property generally includes an obligation of a U.S. person, but in a 1988 Notice the IRS announced it would exclude an obligation collected within 30 days from the time it is incurred if the CFC does not hold for 60 days or more during the taxable year obligations that would otherwise be investments in United States property. 2 In order to facilitate the near-term liquidity of U.S. corporations, the IRS issued a 2008 Notice that, for a limited time, modified the 30-day rule to cover obligations that were collected within 60 days from the time incurred and extended the 60-day limit on holding obligations that would otherwise be United States property to 180 days. 3 The Notice applied to the first two taxable years of a CFC ending after October 3, 2008, but not to taxable years beginning after December 31, Guidance Early in 2009, the IRS extended the 2008 Notice to apply to a third consecutive taxable year, if any, that ends after October 3, 2008 and on or before December 31, 2009, 4 and at the end of 2009 it extended that Notice for an additional consecutive taxable year so long as the taxable year does not begin on or after January 1, A controlled foreign corporation may apply the Notice or the prior 30-day rule, but not both. 5 Definition of Readily Marketable United States property for these purposes does not include an obligation of a U.S. person to the extent the principal amount is less than or equal to the fair market value of readily marketable securities sold or Notice , I.R.B (December 28, 2009). Notice , C.B. 445 (September 16, 1988). Notice , I.R.B (October 6, 2008). For a description of this Notice and much of the earlier guidance referenced throughout this memo, see Sullivan & Cromwell LLP, The IRS and the Treasury Department Provide Guidance in Response to Recent Market Turmoil (October 22, 2008). Notice , I.R.B (January 14, 2009). Notice , I.R.B (December 28, 2009). -2-

3 purchased pursuant to a sale and repurchase (or repo ) agreement, or otherwise posted or received as collateral. 6 In response to uncertainty as to whether a security was readily marketable for the purposes of determining whether an obligation of a U.S. person is United States property, the IRS issued a Revenue Procedure which provides that the IRS will not assert that a security is not readily marketable if the security was of a type that was readily marketable at any time within three years prior to May 12, The Revenue Procedure applied to determinations relevant for the 2007 and 2008 calendar years, and in early 2009 the IRS extended the Revenue Procedure to apply to the 2009 calendar year. 8 Guidance On December 24, 2009 the IRS extended the Revenue Procedure to the 2010 calendar year. 9 TEMPORARY RELIEF FROM THE AHYDO RULES UPDATE: Notice , issued on December 24, 2009, extends the relief from the AHYDO rules provided in the Code until December 31, 2010, if the AHYDO is a qualified obligation. 10 A corporation is not allowed to deduct the disqualified portion of the original issue discount on an applicable high-yield debt obligation ( AHYDO ), and the corporation s deduction for the remaining portion of the original issue discount is deferred until the original issue discount is paid in cash (or in property). 11 An AHYDO is a debt instrument with a maturity date more than five years from the date of issue, a yield to maturity equal to or exceeding a statutorily prescribed rate, and significant original issue discount. 12 The determination of when the obligation is an AYHDO is generally made when the obligation is first issued. In 2009, Congress suspended the application of the AHYDO rules to an AHYDO that was issued in the period beginning on September 1, 2008 and ending on December 31, 2009 in exchange (including a deemed exchange resulting from a modification of the debt instrument) for an obligation of the same issuer that was not an AHYDO To qualify for this exception, the U.S. or foreign person must be acting in the ordinary course of its business and must be a dealer in securities or commodities. IRC Section 956(c)(2)(J). Rev. Proc , I.R.B (May 12, 2008). Notice Notice Notice , I.R.B (December 24, 2009). IRC Section 163(j). As defined in Section 163(i)(2). American Recovery and Reinvestment Act of 2009, Pub. L. No , 123 Stat. 115 (February 17, 2009), which added Section 163(e)(5)(F) to the Code. -3-

4 Guidance At the end of 2009, the IRS extended the statutory relief from the AHYDO rules until December 31, 2010 if the AHYDO is a qualified obligation. 14 Generally, an AHYDO is a qualified obligation if: (1) the AHYDO is issued in 2010 in exchange (including a deemed exchange resulting from a modification of the debt instrument) for an obligation of the same issuer that is not an AHYDO; (2) the AHYDO is not issued to a related person; and (3) the AHYDO would not be an AHYDO if its issue price were increased by the amount of any discharge of indebtedness income realized by the issuer (or obligor) upon the exchange. 15 SECTION 382 LOSS CARRYFORWARDS FOLLOWING AN OWNERSHIP CHANGE Guidance on Stock Issued to Treasury Pursuant to EESA UPDATE: The IRS has issued guidance that amplifies the rules issued in 2008 and earlier in 2009 on the application of the Section 382 loss limitation rules to interests acquired and sold by Treasury. In particular, the new rules provide that the sale by Treasury of stock it acquired as part of the Emergency Stabilization Act of 2008 ( EESA ) to the public will not cause this new public group s ownership of the company to have increased for the purposes of Section The Notice also extends many of the provisions to covered instruments: instruments that were exchanged for instruments issued to Treasury under EESA. Under Section 382, a corporation s deduction for net operating loss carryovers and recognized built-in losses is limited after an ownership change. 17 An ownership change occurs with respect to a corporation, if, immediately after the close of a testing date, the percentage of stock of the corporation owned by one or more 5% shareholders has increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such shareholders at any time during the testing period (generally, three years). 18 Generally, a new public group is created if a 5% shareholder sells stock of the loss corporation to the public Notice Additionally, the AHYDO cannot pay interest that would be treated as contingent interest for purposes of Section 871(h)(4) (without regard to Section 871(h)(4)(D)) and the issue price of the AHYDO must be determined under either Section 1273(b)(1), 1273(b)(2), 1273(b)(3), or 1274(b)(3). Notice , I.R.B (December 14, 2009). The limitation is extended by Section 383 to capital loss carryovers and credits. Temporary Treasury Regulations Sections T(a)(1), (d)(1). Temporary Treasury Regulations Section T(j)(3)(i). Generally, a New Public Group will only be created if some of the purchasers of the shares from Treasury own less than 5 percent of the sold stock after the sale. -4-

5 The IRS issued a Notice in 2008 which provided rules for when shares of a loss corporation acquired by the U.S. Treasury pursuant to EESA would not cause Treasury s ownership in the loss corporation to increase for the purposes of the Section 382 loss limitation rules. 20 Guidance Over the course of 2009, the IRS issued three additional Notices that amended and superseded the 2008 Notice, most recently Notice , issued on December 11, The cumulative effect of the amendments is contained in that Notice. Consistent with the prior Notices, it provides that: Instruments issued to Treasury under EESA programs (except for TARP CAP 22 ) denominated as debt will be treated as such, instruments denominated as preferred stock will be treated as stock described in Section 1504(a)(4) of the Code, and instruments issued to Treasury pursuant to TARP CAP will be classified under general federal income tax principles; Warrants held by Treasury will be treated as unexercised options for Section 382 purposes; 23 Any amount an issuer receives in exchange for instruments issued to Treasury will be treated as consideration for such instruments; Shares of a loss corporation acquired by Treasury pursuant to EESA will not cause Treasury s ownership in the loss corporation to increase over the lowest percentage owned on any earlier date (consequently, purchases pursuant to EESA by Treasury will not result in ownership changes); Such shares will be considered outstanding for purposes of determining the percentage of the loss corporation stock owned by other 5% shareholders on a testing date, thereby reducing the circumstances in which other shareholders transactions will result in ownership changes; 24 and Notice , I.R.B (October 14, 2008). For a discussion of Notice , see Sullivan & Cromwell LLP, Internal Revenue Service Notices Minimize Tax Consequences of Transactions Completed Under the Emergency Economic Stabilization Act (October 14, 2008). See Notice , I.R.B (December 14, 2009), amending and superseding Notice , I.R.B. 901 (April 13, 2009), amending and superseding Notice , I.R.B. 516 (January 30, 2009), amending and superseding Notice , I.R.B (October 14, 2008). For further discussion of Notice , see Sullivan & Cromwell LLP, The Internal Revenue Service Further Expands the Circumstances in Which Equity Investments by Treasury Will Not Result in an Ownership Change that Limits the Use of Net Operating and Capital Losses (including Built-In Losses) and Credits (December 15, 2009). TARP CAP, defined in Notice , refers to the Capital Assistance Program for publicly traded issuers. Notwithstanding this general rule, warrants issued pursuant to Private CPP (the Capital Purchase Program for private issuers) will be considered an ownership interest in the underlying stock (treated as preferred stock described in Section 1504(a)(4)) and warrants issued pursuant to S Corp CPP (the Capital Purchase Program for S Corporations) will be treated as an ownership interest in the underlying indebtedness. For purposes of measuring shifts in ownership by any 5% shareholder on any testing date occurring on or after the date on which the loss corporation redeems shares of its stock held by Treasury that were acquired pursuant to EESA, the redeemed shares will be treated as if they had never been outstanding. -5-

6 Any capital contribution made by Treasury to a loss corporation pursuant to EESA will not be considered to have been made as part of a plan to avoid or increase any Section 382 limitation. Importantly, Notice addresses sales by Treasury and amends the previous guidance by adding that: If Treasury sells stock it was issued pursuant to EESA to the public, the public group that purchases the stock will not be considered to have increased its ownership in the issuing corporation for the purposes of Section 382 solely on account of the sale. The group s ownership will be increased, however, on account of transactions other than a sale by Treasury (including pursuant to stock issuances and certain redemptions.) 25 Stock Treasury sells to the public will be considered outstanding for purposes of determining the percentage of stock owned by other 5% shareholders, and Section 382 (and the regulations thereunder) will otherwise apply to the new public group in the same manner as it applies to other public groups. The exemption for sales by Treasury does not apply to sales that do not create a public group for example, the exemption does not apply to sales that are made to holders that own, directly or constructively, 5% or more of the corporation. With the exception of those described in the first two bullet points above, these provisions will apply to covered instruments instruments Treasury acquires in exchange for an instrument that was issued to Treasury under the EESA Program, or instruments acquired in exchange for other covered instruments. Bad Debts or Loan Losses of a Bank UPDATE: On February 17, 2009, the President signed into law the American Recovery and Reinvestment Act of ( ARRA ), which revoked Notice on a prospective basis. 27 That Notice had allowed banks to avoid the Section 382 limitation on the use of pre-ownership change bad debt deductions. Notice provided that, for purposes of the post-ownership change limitations, any deduction properly allowed to a bank after an ownership change with respect to losses on loans or bad debts would not be treated as a built-in loss or a deduction that is attributable to periods before the change date. As a consequence, the deduction for these losses would not be subject to the Section 382 limitation Presumably this does not include redemptions by the issuer of stock issued to Treasury pursuant to the EESA Programs since these redemptions are explicitly covered by a different section of the Notice which provides that the shares so redeemed are treated as though they had never been issued. (See fn. 9). However, the Notice does not say this explicitly. Pub. L. No , 123 Stat. 115 (February 17, 2009). For a further discussion of ARRA, including provisions not discussed herein, see Sullivan & Cromwell LLP, Stimulus Package Modifies Rules on Cancellation of Indebtedness Income, Certain High-Yield Debt Obligations, Section 382 Ownership Changes and Net Operating Loss Carrybacks (February 24, 2009). Notice , I.R.B (September 30, 2008). For a further discussion, see Sullivan & Cromwell LLP, Internal Revenue Service Notice Discusses Application of Section 382 to Banks (October 1, 2008). -6-

7 New Legislation ARRA revoked the Notice on a prospective basis, effective for any ownership changes occurring after January 16, Capital Contributions Not Treated as Part of a Plan UPDATE: As of this date, the IRS has not issued regulations as contemplated by Notice , relating to the treatment of capital contributions for purposes of the Section 382 limitation. 28 Those regulations are intended to provide further guidance on when a capital contribution will be respected for purposes of calculating the carryforward limitation under Section 382. Taxpayers may continue to rely on the guidance as set forth in the Notice. After an ownership change, a corporation s annual deduction for net operating loss carryovers and net recognized built-in losses is generally limited to an amount equal to the product of the long-term taxexempt rate published by the Internal Revenue Service and the equity value of the corporation at the time of the ownership change. Generally, except as set forth in the regulations, a capital contribution made to a corporation that undergoes an ownership change will be presumed to be part of a plan which has a principal purpose of avoiding or increasing the Section 382 limitation if it is made during the twoyear period ending on the change date. As a result, such contributions are generally disregarded in calculating the fair market value of the loss corporation, and thus do not increase the carryforward limitation. In 2008 the IRS issued Notice , which provides that a capital contribution will not be presumed to be part of a plan which has a principal purpose of avoiding or increasing the Section 382 limitation solely as a result of having been made during the two-year period ending on the change date, notwithstanding the general statutory rule, unless the contribution is, based on all the facts and circumstances, part of a plan which has a principal purpose of avoiding or increasing the carryforward limitation. The Notice also provides safe harbors for capital contributions in a number of situations. 29 In addition, the Notice contemplates the issuance of Regulations to the effect set out above and may be relied on with respect to an ownership change that occurs in any taxable year of the loss corporation ending on or after September 26, Notice , I.R.B (September 26, 2008). Furthermore, the facts-and-circumstances test will not apply in determining the value of the stock of a loss corporation immediately after an ownership change in certain insolvency transactions. -7-

8 Guidance As of this date, the IRS has not issued Regulations as contemplated by the Notice, although it has issued private letter rulings with respect to capital contributions. 30 Taxpayers may continue to rely on the guidance as set forth in the Notice. NET OPERATING LOSS CARRYBACK PERIOD UPDATE: The Worker, Homeownership, and Business Assistance Act of (the Act ) expanded the five-year loss carryback period to all businesses. (Previously, under ARRA, it had only applied to certain eligible small businesses.) The new rule applies to net operating losses for any taxable year ending after December 31, 2007 and beginning before January 1, In general, a net operating loss can be carried back two years and forward twenty years. ARRA extended the loss carryback period to up to five years for certain eligible small businesses. 32 New Legislation The Act expanded the loss carryback extension to all businesses and to include net operating losses for any taxable year ending after December 31, 2007 and beginning before January 1, However, if a taxpayer extends the net operating loss carryback period under the Act and not under ARRA (i.e., the taxpayer is not an eligible small business, or is an eligible small business and elects to extend the net operating loss carryback period under the Act), the amount of a net operating loss carried back to the fifth tax year proceeding the loss is limited to 50% of a taxpayer s taxable income for that year. Moreover, the extension of net operating loss carryback periods under the Act does not apply to taxpayers who have received or who receive in the future certain direct benefits under EESA. AUCTION RATE SECURITIES UPDATE: The IRS has recently issued a Notice which extends to December 31, 2010 the date on or before which an initial liquidity facility may be added to support certain auction rate preferred stock See PLR (September 24, 2009). Pub L. No , 123 Stat (November 6, 2009). The extended carryback period is available at the election of the taxpayer. Rev. Proc , I.R.B. 935 (April 25, 2009) advises taxpayers on how to make the election. An election, once made, is irrevocable. Rev. Proc , I.R.B (November 20,2009) advises taxpayers on how to make the election. Notice , I.R.B (December 22, 2009). -8-

9 An auction rate security is a security the payment rate on which is reset periodically (typically every seven to 28 days), pursuant to an auction rate-setting process or similar rate-setting process. A failed auction or remarketing occurs if the auction or remarketing fails to produce buyers for all interested sellers at a payment rate that is at or below the maximum payment rate specified by the terms of the auction rate security. Auction rate securities may be in the form of debt securities (typically issued by municipalities) or preferred stock (typically issued by closed-end regulated investment companies). In response to auction failures, issuers and third parties sought to add liquidity facilities to support auction rate preferred stock. In order to provide certainty on Federal income tax issues resulting from efforts to address liquidity in the auction rate securities market, in 2008 the IRS issued a Notice providing that, if the conditions in the Notice are met, the IRS will not challenge the treatment of auction rate preferred stock as equity for Federal income tax purposes because a liquidity facility supports the auction rate preferred stock. 35 Also, in the case of certain partnerships holding auction rate preferred stock, the IRS will not challenge the equity characterization of interests in the partnership for Federal income tax purposes as a result of adding a liquidity facility to support the variable-rate interests in the partnership if the conditions of the Notice are met. Under the terms of the Notice, the auction rate preferred stock had to be outstanding on February 12, 2008 (or, under certain conditions, issued after that date to refinance auction rate preferred stock that was outstanding on that date), and the liquidity facility had to be an initial liquidity facility entered into after February 12, 2008 and on or before December 31, 2009 (or a liquidity facility which renews, replaces, or extends such initial liquidity facility). Guidance Notice extends the date on or before which an initial liquidity facility may be added to support certain auction rate preferred stock to December 31, STOCK DISTRIBUTIONS BY REAL ESTATE INVESTMENT TRUSTS AND REGULATED INVESTMENT COMPANIES UPDATE: The IRS recently issued a Revenue Procedure which amplifies and supersedes provisions of earlier Revenue Procedures on distributions from REITs and RICs. 36 The Revenue Procedure extends dividend treatment to certain stock dividends declared on or before December 31, 2012, with respect to a taxable year ending on or before December 31, Notice , I.R.B (June 25, 2008). Rev. Proc , I.R.B (December 23, 2009). -9-

10 REITs and RICs are entitled to a dividends-paid deduction for distributions to shareholders that are not preferential and are generally required to distribute at least 90% of their real estate trust or investment company taxable income, as the case may be. 37 Many REITs and RICs have experienced cash-flow challenges and have sought to fulfill the distribution requirements applicable to REITs and RICs with a distribution that largely consists of stock, rather than a distribution made entirely in cash. 38 To facilitate these distributions, the IRS issued two Revenue Procedures which provided that the IRS would treat certain qualifying stock distributions made by REITs and RICs as taxable dividends. 39 The Revenue Procedures applied to distributions made in respect of a taxable year ending on or before December 31, 2009 that were declared on or after January 1, Guidance Revenue Procedure extends the earlier Revenue Procedures to stock dividends declared on or before December 31, 2012, with respect to a taxable year ending on or before December 31, The Revenue Procedure further provides that if the combination of stock and cash received differs between shareholders, any differences in the fair market value of the stock on the date of distribution will not cause IRC Sections 857(a)(1) & 852(a)(1). A REIT must also distribute at least 90% of its net income from foreclosure property, but may reduce the required distribution by excess non-cash income, and a RIC must also distribute at least 90% of its net tax exempt income. The amount of a distribution that is a dividend is dependent on a corporation s earnings and profits. With respect to earnings and profits from cancellation of debt income, the IRS has promulgated a special rule applicable only to REITs and RICs. ARRA allowed taxpayers to defer cancellation of debt income incurred while repurchasing their own debt. In a 2009 Revenue Procedure, the IRS provided that taxpayers who defer their cancellation of debt income must increase their earnings and profits during the year of the election (i.e., the year in which the income is deferred). REITs and RICs, however, must increase their earnings and profits in the year in which the income is included. Rev. Proc , I.R.B (August 17, 2009). Rev. Proc , I.R.B. 1373; Rev. Proc , I.R.B A discussion of Revenue Procedure can be found in the Sullivan & Cromwell LLP publication entitled Real Estate Investment Trusts: IRS Issues Temporary Guidance on Stock Distributions by Real Estate Investment Trusts (December 10, 2008). A discussion of Revenue Procedure can be found in the Sullivan & Cromwell LLP publication entitled Regulated Investment Companies: IRS Extends Guidance on Stock Distributions to Publicly Traded Regulated Investment Companies (January 12, 2009). Qualification for the benefits of the earlier Revenue Procedures requires, among other things, that: (1) the REIT or RIC is publicly traded on an established securities market in the United States; (2) the distribution is declared with respect to a taxable year ending before January 1, 2010; (3) the distribution permits shareholders to elect the receipt of either cash or stock subject to a cap, (the Cash Limitation ) which can limit the total amount of cash to 10% or more of the declared distribution; (4) the amount of stock distributed to a shareholder that receives stock in lieu of cash is determined using a formula that equates the value of the stock received with the amount of cash that would have otherwise been payable; and (5) if the cash option is oversubscribed, each shareholder electing cash will receive an amount of cash pro rata to the shareholder s entitlement under the declaration (and thus never less than 10% of the shareholder s entitlement). -10-

11 the distribution to be a preferential distribution. 41 Other than the extension of eligibility dates, the rules for qualification are the same as those set forth in the earlier Revenue Procedures. TAX-EXEMPT BONDS UPDATE: On December 22, 2009, the IRS issued a Notice which extends the expiration date of certain provisions of earlier Notices relating to (1) the time period over which certain tax-exempt bonds may be repurchased and held by their government issuers without being treated as reissued and (2) the treatment of waivers of interest rate caps on tax-exempt auction rate bonds. 42 The actual or deemed reissuance of tax-exempt obligations triggers the retesting of all the requirements that a new issue of tax-exempt obligations must satisfy in order for interest on the obligations to be taxexempt. Generally, if a tax-exempt bond undergoes a significant modification it is deemed to have been reissued; if a tax-exempt bond is repurchased by its governmental issuer it is treated as retired. However, the IRS has issued guidance providing for a 90-day grace period within which a governmental issuer may repurchase and resell certain of their tax-exempt obligations without the transaction resulting in a reissuance or retirement of the obligation. 43 Two Notices issued in extended the normal 90-day grace period to 180 days. 45 This extended grace period applied to obligations repurchased prior to December 31, Additionally, the Notices provided that certain waivers of interest rate caps on tax-exempt auction rate bonds would be disregarded for the purposes of determining whether there had been a significant modification 46 of the bond for the period through December 31, One of the Notices further provided that certain tax-exempt qualified tender bonds and tax-exempt commercial paper purchased by the governmental issuer would not be treated as retired or reissued regardless of when purchased provided they were held by the governmental issuer no later than December 31, 2009, and refinancing of purchased tax-exempt commercial paper during this period would be treated as the same issuance as the purchased paper IRC Section 562(c). Notice , I.R.B (December 22, 2009). Notice , I.R.B (February 19, 2008) (which in turn modifies special reissuance standards under Notice , C.B. 543 (January 1, 1988)). Notice , I.R.B (October 1, 2008), amending and superseding Notice , I.R.B (March 25, 2008). Applicable solely for purposes of Section 103 and Sections 141 through 150. As defined in Treasury Regulations Section Notice

12 Guidance Notice extends the expiration date of the temporary rule that lengthened to 180 days the time period that state and local governments can purchase and hold their tax-exempt obligations without there being a deemed reissuance of the obligation, and also extends the rules regarding the repurchase of tender bonds and commercial paper. Those rules now expire on December 31, The Notice also extends to December 31, 2010 the period for which a temporary waiver of an interest rate cap on auction rate bonds may be disregarded for purposes of determining whether there had been a significant modification of the bond. REMICS AND FIXED INVESTMENT TRUSTS UPDATE: The IRS has issued guidance under which, if certain conditions are met, modifications of mortgage loans will not cause a securitized investment vehicle to lose its status as a REMIC or fixed investment trust. Revenue Procedures Except as provided in Regulations, 48 a significant modification of an obligation held by a REMIC will cause the modified obligation to be treated as newly issued in exchange for the obligation that it replaced. One or more significant modifications of loans held by a REMIC may terminate its qualification as a REMIC. Modifications of mortgages held by a trust may likewise cause the trust not to be a fixed investment trust. Additionally, in the case of a REMIC, a tax equal to 100% of the net income derived from prohibited transactions is imposed on the REMIC. 49 With some exceptions, the disposition of a qualified mortgage is a prohibited transaction. 50 Guidance In order to give loan servicers, REMICs, and fixed investment trusts greater flexibility to modify mortgage terms without adverse tax consequences, the IRS has issued a number of Revenue Procedures which describe mortgage modifications that will not result in an IRS assertion that (1) an entity ceased to be a REMIC because the modifications are not among the exceptions listed in the Regulations; (2) the modifications are prohibited transactions because the modifications resulted in one or more dispositions of qualified mortgages and the dispositions are not among the statutory exceptions; 51 (3) a trust ceased to Under Treasury Regulations Section 1.860G-2(b)(3). In particular, if a change in the terms of an obligation is occasioned by default or a reasonably foreseeable default, the change is not a significant modification. IRC Section 860F(a)(1). The exceptions are for a disposition that is pursuant to (1) the substitution of a qualified replacement mortgage for a qualified mortgage, (2) a disposition incident to the foreclosure, default, or imminent default of the mortgage, (3) the bankruptcy or insolvency of the REMIC, or (4) a qualified liquidation. Under Section 860F(a)(2)(A)(i)-(iv). -12-

13 be a fixed investment trust 52 because the modifications reflect a power to vary the investment of the certificate holders; or (4) an entity ceased to qualify as a REMIC because the modifications resulted in a deemed reissuance of the REMIC regular interests. The following modifications will not cause the IRS to assert any of the above: Modifications made to residential mortgages in an organized foreclosure prevention program or in other circumstances where the holder or servicer reasonably believes both that the original loan has a significant risk of foreclosure and that the modified loan substantially reduces that risk. This applies to determinations made by the IRS after May 16, 2008 with respect to modifications that are effected on or before December 31, Modifications made in accordance with the American Securitization Forum s Statement of Principles, Recommendations and Guidelines for a Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans that was issued on July 8, This applies to transactions occurring on or before July 31, Modifications made pursuant to the Home Affordable Mortgage Program, effective for Modifications made on or after March 4, Modifications made to loans that: (i) are not secured by a residence with fewer than five dwelling units that is the principal residence of the issuer; and (ii) based on all facts and circumstances, the holder or servicer reasonably believes both that the original loan has a significant risk of foreclosure and that the modified loan substantially reduces that risk. However, this guidance only applies to these loans if at startup no more than 10% of the principal of the REMIC s or fixed investment trust s assets are represented by loans which were overdue by 30 days or more or for which default was reasonably foreseeable. 56 Final Regulations Additionally, the IRS finalized Regulations providing additional circumstances in which a REMIC s modification of a mortgage loan will be permitted. 57 The Regulations address modifications often made to commercial mortgages and provides that the following modifications will be permitted if made by a REMIC: Under Treasury Regulations Section (c). Rev. Proc , I.R.B (May 16, 2008). For a further discussion, see Sullivan & Cromwell LLP, Real Estate Mortgage Investment Conduits and Fixed Investment Trusts (May 19, 2008). Rev. Proc , I.R.B (July 8, 2008). For a further discussion, see Sullivan & Cromwell LLP, Real Estate Mortgage Investment Conduits and Fixed Investment Trusts (July 9, 2008). A copy of the American Securitization Forum s Statement of Principles is appended to Revenue Procedure Rev. Proc , I.R.B (April 10, 2009). Rev. Proc , I.R.B (September 15, 2009). For REMICs, this is test is applied three months after the startup day; for fixed investment trusts this is test is applied as of all dates when assets were contributed to the trust. T.D (September 16, 2009). For a further discussion of the Regulations, see Sullivan & Cromwell LLP, IRS Gudiance on Modifications of Commercial Mortgages Held by Real Estate Mortgage Investment Conduits and Fixed Investment Trusts (September 16, 2009). -13-

14 Waiver of a due-on-sale or a due-on-encumbrance clause; A modification that releases, substitutes, or otherwise adds a substantial amount of collateral, so long as the mortgage continues to be principally secured by an interest in real property. A change in the nature of the obligation from recourse to nonrecourse (or vice versa), so long as the obligation continues to be principally secured by an interest in real property. The Regulations also state that a lien release will not cause a mortgage to lose its status as a qualified mortgage so long as (1) the lien release would not result in a significant modification or would be exempted from the definition of significant modification under the special rules applicable to REMICs; and (2) the loan remains principally secured by real property after the release of the loan. Principally Secured by an Interest in Real Property A mortgage is only a qualified mortgage if it is principally secured by an interest in real property, which requires that the fair market value of the real property securing the loan be equal to at least 80% of the adjusted issue price of the loan at the time the loan is originated or contributed to the REMIC. For a modified loan, the 80% test must be met at the time of the modification. The Final Regulations state that a modified obligation will be deemed to meet the 80% test if the servicer reasonably believes that the modified loan meets the test. 58 A servicer s reasonable belief can be based on any of the following: (1) a current appraisal performed by an independent appraiser; (2) an appraisal obtained at the time the loan was originated that has been updated to reflect any changes in value; (3) the sales price of the interest if a substantially contemporary sale has occurred in which the buyer assumes the seller s obligation under the mortgage; or (4) some other commercially reasonable valuation method. Additionally, the Final Regulations provide an alternative test under which, if the loan does not meet the 80% test, the loan will nonetheless be principally secured by an interest in real property if the fair market value of the real estate that secures the modified loan equals or exceeds the fair market value of the property that secured the loan prior to modification. 59 The IRS is considering extending this guidance to modifications made by fixed investment trusts, though it has not yet done so. 60 * * * Copyright Sullivan & Cromwell LLP Treasury Regulations Section 1.860G-2(b)(7)(ii). Treasury Regulations Section 1.860G-2(b)(7)(iii). The fair market value of the real property can be determined in any of the ways described above, and the servicer cannot know or have reason to know that this criterion is not satisfied. See Notice , I.R.B (September 16, 2009), requesting comments on whether to extend the safe harbors to fixed investment trusts. -14-

15 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York Judith R. Fiorini fiorinij@sullcrom.com Andrew S. Mason masona@sullcrom.com Andrew P. Solomon solomona@sullcrom.com Willard B. Taylor taylorw@sullcrom.com Washington, D.C. Donald L. Korb korbd@sullcrom.com London Andrew P. Solomon solomona@sullcrom.com -15- NY12528: