International Tax Alert – September 2017

Proposed Regulations Provide Guidance on the Definitions of Registration-Required Obligation and Registered Form

Summary

On September 19, 2017, the Department of the Treasury and the Internal Revenue Service (collectively, “Treasury”), published in the Federal Register proposed regulations (the “Proposed Regulations”) that provide guidance on the definitions of registration-required obligation and registered form, including guidance on the issuance of pass-through certificates and participation interests in registered form. The Proposed Regulations also withdraw a portion of previously proposed regulations regarding the definition of a registration-required obligation. The preamble to the Proposed Regulations (the “Preamble”) states that the Proposed Regulations are necessary to address changes in market practices as well as issues raised by the statutory repeal of the foreign-targeted bearer obligation exception to the registered form requirement. 
 

Details

The classification of an obligation as in bearer or registered form has significant tax implications because a number of Code provisions impose sanctions on issuers and holders of registration-required obligations that are not issued in registered form. For example, issuers of a registration-required obligation that is not in registered form may be denied an interest deduction under IRC §163(f) or may be subject to an excise tax under IRC §4701. Also, IRC §149(a) provides that interest on a registration-required bond is not exempt from tax under IRC §103(a) unless the bond is in registered form. In addition, IRC §§ 871(h) and 881(c) exempt from federal income tax U.S.-source portfolio interest received by a foreign person (the “portfolio interest exception”) only if the obligation with respect to which the interest was paid is in registered form. Similar restrictions are found in IRC §§ 165(j) (generally denying the holder a deduction for a loss sustained on a registration-required obligation not in registered form), 312(m) (generally providing that the issuer’s earnings and profits cannot be decreased by interest paid on a registration-required obligation not in registered form), and 1287 (generally treating the holder’s gain on sale of a registration-required obligation not in registered form as ordinary income).
 
Historically, the Code provisions referenced above generally did not apply to obligations that complied with the foreign-targeting rules of prior IRC §163(f)(2)(B) and §1.163-5(c) (“foreign-targeted bearer obligations”). Under these rules, an issuer could issue foreign-targeted bearer obligations without penalty, provided the obligations were issued under arrangements reasonably designed to ensure that the obligations were sold only to non-U.S. persons. The portfolio interest exception also applies to interest paid on foreign-targeted bearer obligations issued under such reasonable designed arrangements.
 
The Hiring Incentives to Restore Employment Act (the “HIRE Act”), P.L. 111-147, 124 Stat. 71, §502, repealed IRC §163(f)(2)(B) and generally eliminated the special treatment of foreign-targeted bearer obligations. Foreign-targeted bearer obligations issued after March 18, 2012, are subject to the sanctions on bearer form obligations under IRC §§ 149(a), 163(f), 165(j), 312(m), and 1287. The Hire Act also revoked the portfolio interest exception for foreign-targeted bearer obligations, thus requiring that obligations issued after March 18, 2012, be in registered form to qualify for that exception. The HIRE Act did not, however, repeal the foreign-targeted bearer obligation exception to the excise tax under IRC §4701.^[1]
 
On March 26, 2012, Treasury issued Notice 2012-20 (the “Notice”) to provide additional guidance on the definition of registered form. Under the Notice, an obligation is considered to be in registered form if it is issued either through a dematerialized book entry system in which beneficial interests are transferable only through a book entry system maintained by a clearing organization (or by an agent of the clearing organization) or through a clearing system in which the obligation is effectively immobilized. In addition, the Notice states that, for purposes of determining when an obligation is a registration-required obligation under IRC §4701, rules identical to the foreign-targeting rules under IRC §163(f)(2)(B), prior to its amendment by the HIRE Act, and §1.163-5(c) will apply to obligations issued after March 18, 2012.
 
Consistent with the Notice, the Proposed Regulations amend the definition of registered form to take into account current market practices and changes made by the Hire Act, including the repeal of the foreign-targeting rules in IRC §163(f)(2)(B). First, the Proposed Regulations provide 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, maintained by the issuer of the obligation, an agent of the issuer, or a clearing organization. Second, the Proposed Regulations provide that an obligation represented by a physical certificate in bearer form will be considered to be in registered form if the physical certificate is effectively immobilized. Third, the proposed regulations permit holders of obligations (or interests in obligations) to have a right to obtain physical certificates evidencing the obligation (or interests in the obligation) in bearer form without causing the obligation to be treated as not in registered form in two circumstances: (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.
 
In addition, the Proposed Regulations amend the definition of a registration-required obligation in two ways. First, the Proposed Regulations specify the types of obligations that are treated as “of a type offered to the public” and withdraw the 1993 proposed regulations. Second, the Proposed Regulations take into account comments requesting clarification on the types of arrangements that qualify as pass-through certificates (e.g., a certificate issued by an investment entity that holds a pool of obligations, such as mortgage loans where each pass-through certificate represents an interest in the investment entity).
 
To the extent possible, the Proposed Regulations simplify the definitions of registered from and registration-required obligation by centralizing the rules in §1.163-5.
 
For a complete discussion of these rules along with other rules in the Proposed Regulations, see the Preamble and the Proposed Regulations.

The Notice stated that regulations incorporating the guidance described in the Notice will be effective for obligations issued after March 18, 2012. Accordingly, the Proposed Regulations will generally apply to obligations issued after March 18, 2012. However, taxpayers may apply the rules in section 3 of the Notice, including the default exception, for obligations issued prior to publication of a Treasury decision adopting these rules as final regulations in the Federal Register. The rules related to pass-through certificates, participation interests and regular interests in REMICs and the rules related to obligations not of a type offered to the public are not described in the Notice and, therefore, will apply only to obligations issued after the publication of a Treasury decision adopting these rules as final regulations in the Federal Register, except as otherwise provided in the next sentence. The existing regulations under §5f.103-1 will continue to apply to tax exempt bonds issued prior to the date 90 days after publication of a Treasury decision adopting these rules as final regulations in the Federal Register.
 

BDO Insights

As mentioned above, various Code sections may impose negative tax implications to issuers of a registration-required obligation that is not in registered form. BDO can assist issuers and holders of obligations in registered form as well as issuers and holders of registration-required obligations to navigate and understand these complex rules related to registered form and registration-required obligations.