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On December 8, 2000, the Internal Revenue Service released an advance copy of Revenue Procedure 2001-12 ("Rev. Proc. 2001-12"), which will appear in Internal Revenue Bulletin 2001-2, dated January 8, 2001. Rev. Proc. 2001-12 adds an alternative "safe harbor" for transfers of noneconomic residual interests ("NERs") in REMICs and FASITs to certain qualifying entities in addition to the minimum transfer price safe harbor in proposed regulations (the "Proposed Regulations") issued in February 2000. Under the new safe harbor, the reasonability of the actual transfer price is taken into account in determining whether the transferor reasonably expects the transferee to pay the tax on the NER. The modified rules are effective retroactively to February 4, 2000.
A residual interest in a REMIC or FASIT is a NER if the present value of its net tax liabilities exceed the present value of all expected distributions on the residual interest. Under Treasury Regulations Section 1.860E-1(c), a transfer of a NER is ignored for tax purposes, and the transferor is treated as the owner and required to report income and pay tax thereon, if the transferor should have known that the transferee would be unwilling or unable to pay the tax thereon when due ("improper knowledge").
Current Requirements. Under current regulations, there is a two-fold safe harbor creating a presumption that the transferor lacked improper knowledge. First, the transferor must conduct a reasonable investigation of the transferee’s financial condition that indicates an ability and willingness to pay the tax. Second, the transferee must provide representations as to its understanding that the tax liabilities associated with holding a residual interest may exceed cash flows generated by the interest and its intention to pay those taxes as they become due. Rev. Proc. 2001-12 repeats these requirements and then adds two alternative tests, only one of which needs to be satisfied.
Minimum Price Test. The first test repeats the test in the Proposed Regulations and is met if the present value of the anticipated tax liabilities associated with holding the NER (using the highest marginal corporate tax rate, currently 35%) does not exceed the sum of (i) the present value of any consideration paid to the transferee to take the NER, (ii) the present value of expected future distributions on the NER, and (iii) the present value of the anticipated tax savings from future losses on the NER. Present values are computed using either (a) the applicable Federal rate (a basket of short, medium or long-term Treasury rates corresponding to the life of the related REMIC or FASIT), or (b) a lower rate that the transferee demonstrates is a rate at which it regularly borrows, in the course of its trade or business, substantial funds from unrelated third parties.
Eligible Transferee Test. The second, new alternative is met if (i) the transferee has at the time of the transfer, and had for its two fiscal years preceding the transfer, gross assets of at least $100 million and net assets of at least $10 million for financial reporting purposes, (ii) the transferee is a domestic "C" corporation that agrees in writing to make any subsequent transfer only to another domestic "C" corporation in a safe harbor transfer, and (iii) the circumstances surrounding the transfer, including the price actually paid to the transferee, "reasonably indicate" to the transferor that the transferee will pay the taxes. For purposes of the third requirement, the minimum transfer price test need not be used, but "if the amount of consideration is so low that under any set of reasonable circumstances a reasonable person would conclude that the taxes associated with holding the residual interest will not be paid, then the transferor is deemed to know that the transferee cannot or will not pay."
Thus, while the minimum transfer price safe harbor need not be met, the price that is paid to the transferee must, under reasonable assumptions, including but not limited to prepayment rates, expected losses and reinvestment rates, adequately compensate the transferee for assuming the tax liability on the NER. The eligible transferee safe harbor also requires that (i) the gross and net asset tests may not include any obligation of a related person or an asset acquired principally to satisfy the test, (ii) the transferor may not know or have reason to know that the transferee will not honor the restrictions on subsequent transfers of the NER, (iii) the transferee may not be a foreign branch of an otherwise eligible domestic "C" corporation, or part of any other arrangement by which the NER is subject to net taxation by a foreign country or U.S. possession.
Examples given of ineligible transfers include a transfer to a partnership or a transfer to an otherwise eligible transferee that has bought a number of NERs early in the year that meet the eligible transferee safe harbor but, to the transferor’s knowledge, does not have the financial capacity to meet its tax obligations with respect to additional NERs.
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