SECTION 2. BACKGROUND

Enacted by the Tax Reform Act of 1986 (the 1986 Act), the real estate mortgage investment conduit (REMIC) provisions of the Internal Revenue Code permit a qualifying entity or arrangement, which finances mortgages by issuing multiple classes of interests, to elect REMIC status. In general, a REMIC is not treated as a taxable entity. Instead, the holders of the residual interests in a REMIC take into account the REMIC’s net income or net loss.

A REMIC issues regular interests and a single class of residual interests. Regular interests in a REMIC are treated as debt, and holders of these interests must include interest income from the regular interests under an accrual method. The REMIC deducts interest accruals on the regular interests in computing its net income or net loss. The holders of the residual interests in a REMIC take into account the net income or net loss of the REMIC. A portion of the net income allocated to the

residual interest holders may be an excess inclusion within the meaning of section 860E(c). An excess inclusion may not be offset by net operating losses, is treated as unrelated business taxable income (UBTI) by certain tax-exempt organizations, and is not eligible for any reduction in withholding tax (by treaty or otherwise) in the case of a nonresident.

In addition, the REMIC provisions seek to ensure that excess inclusion income does not escape current taxation. Some of these provisions are designed to prevent certain tax-exempt entities (disqualified organizations) from being direct holders of a REMIC residual interest. Others impose tax on certain pass-through entities that have excess inclusion income allocable to a record owner that is a disqualified organization. For this purpose, pass-through entities (as defined in section 860E(e)(6)(B)) include REITs, RICs, and nominees; and disqualified organizations (as defined in section 860E(e)(5)(B)) include tax exempt entities that are not subject to unrelated business income tax under section 511. For example, a REIT that owns REMIC residual interests must pay any tax imposed by section 860E(e)(6) with respect to excess inclusion income allocable to a shareholder that is a disqualified organization. Rev. Rul. 2006–58, 2006–46 I.R.B. 876 (November 13, 2006), illustrates the application of these provisions to a REIT (or a partnership) that has a charitable remainder trust as a shareholder (or a partner).

Section 860E(d) addresses the tax consequences to a REIT’s shareholders when the REIT holds a REMIC residual interest. The section provides that, if a REIT holds one or more REMIC residual interests, then, under regulations prescribed by the Secretary, the excess of the aggregate excess inclusions determined with respect to those interests over the REIT’s taxable income shall be allocated among the shareholders of the REIT in proportion to the dividends received from the REIT. Any such amounts allocated to a shareholder shall be treated as an excess inclusion with respect to a residual interest held by the shareholder. Section 860E(d) further provides that similar rules apply to RICs, common trust funds, and certain cooperative organizations. Regulations issued under section 860E reserve the portion of the regulations dealing with

the application of section 860E(d). See § 1.860E–1(b).

Congress intended the REMIC regime to be the exclusive vehicle for securitizations issuing multiple-maturity mortgagebacked debt securities. Accordingly, the 1986 Act also enacted TMP provisions, which require an entity that issues such securities without making the REMIC election to be taxed as a separate corporation.

Section 7701(i) defines a taxable mortgage pool as any entity (other than a REMIC) if—

(i) Substantially all of the assets of the entity consist of debt obligations or interests in debt obligations, and more than 50% of these debt obligations or interests are real estate mortgages or interests in real estate mortgages;

(ii) The entity is the obligor under debt obligations that have two or more maturities; and

(iii) The required payments on the debt obligations that the entity issued bear a relationship to the payments to be received by the entity on the debt obligations that it holds as assets.

A portion of an entity may also be a TMP under this definition.

Section 7701(i)(3) provides a special rule for a REIT that is a TMP. Congress generally intended for equity interests in REIT TMPs to be subject to rules similar to those that apply to residual interests in REMICs. Accordingly, section 7701(i)(3) provides that if a REIT, or a qualified REIT subsidiary, is a TMP, then, under regulations prescribed by the Secretary, adjustments similar to the adjustments provided in section 860E(d) are to apply to the shareholders of the REIT. Regulations under section 7701(i) have been issued, but these regulations specifically reserve on the treatment of REIT TMPs. See § 1.7701(i)–4(b).

The Treasury Department and the Service have been advised that a growing number of REITs have recently begun securitizing mortgages by issuing debt obligations that cause the REITs to be TMPs. These securitizations may be effected through a qualified REIT subsidiary or a disregarded entity, such as a securitization trust. In these arrangements, not all of the REIT’s income is attributable to a TMP.

The Treasury Department and the Service have also been advised that, in the

2006–46 I.R.B. 904 November 13, 2006

come to its shareholders in proportion to dividends paid (determined without regard to any special allocation of the expense for any tax paid under section 860E(e)(6)) and inform the shareholders that are not disqualified organizations of the amount and character of the excess inclusion income allocated to them.

860E(e)(6) on the excess inclusion income that is allocable to its shareholders that are disqualified organizations.

860G(b)(2), apply the withholding tax provisions with respect to the excess inclusion portion of dividends paid to foreign persons without regard to any treaty exception or reduction in tax rate.

come, a pass-through entity, other than a REIT, RIC, or nominee, must—

come to its partners, participants, beneficiaries, or patrons (collectively, “owners”) in accordance with applicable provisions (section 702, section 584, subchapter J, or part I of subchapter T) and inform any owners that are not disqualified organizations of the amount and character of the excess inclusion income that has been allocated to them.

860E(e)(6) on excess inclusion income that is allocable to disqualified organizations.

860G(b)(2), apply the withholding tax provisions with respect to the excess inclusion portion of the payments made to foreign persons without regard to any treaty exception or reduction in tax rate.

come, a nominee must—

absence of regulations or other guidance under section 7701(i)(3), taxpayers are uncertain about how to apply section 7701(i)(3) to REIT TMPs and to shareholders of REIT TMPs. Taxpayers are similarly uncertain about how to apply section 860E(d) to RICs (and other pass-through entities) that receive excess inclusion income (for example, a RIC holding shares of a REIT that is required by sections 7701(i)(3) and 860E(d) to allocate excess inclusion income to its shareholders).