May 8, 1992
TO: TAX COMMITTEE NO. 18-92
RE: REVENUE RULING ON TRANSFER OF A SUBORDINATED INTEREST IN
AN INVESTMENT TRUST
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The Internal Revenue Service has recently issued the
attached Revenue Ruling dealing with the effect of the sale of a
subordinated interest in a trust with a senior/subordinated
structure on the tax status of the trust. The Service concluded
that the sale of the subordinated interest would not cause the
investment trust to be classified as an association taxable as a
corporation or a partnership. This is a reversal of the
Service's previous position, in which they had held that any
transfer of the subordinated interest by the trust sponsor would
cause the trust to fail to be a trust for tax purposes.
The investment trust in the Revenue Ruling was formed by
the transfer to a trust of a pool of fully-amortizing, fixed-rate
automobile loans in exchange for two classes of pass-through
certificates: a Senior class and a Subordinated class. The
Senior certificates were entitled to 90 percent of all
distributions, while the Subordinated certificates were entitled
to 10 percent. Under the terms of the trust, any shortfalls in
payments on the pooled loans arising as a result of defaults or
delinquencies would first reduce the distributions to the
Subordinated certificate holders. Only after shortfalls have
reduced the distributions on the Subordinated certificates to
zero will the distributions to Senior certificate holders be
affected.
Under Treas. Reg. section 301.7701-4(c)(1), a multiple
class investment trust is ordinarily classified for tax purposes
as an association or a partnership. However, such a trust will
be classified as a trust for tax purposes if (1) there is no
power under the trust agreement to vary the trust's investments,
and (2) the trust is formed to facilitate direct investment in
the assets of the trust and the multiple classes of ownership
interest are incidental to that purpose. The regulations contain
an example identical to the fact pattern in the Revenue Ruling,
except that the subordinated interest is retained by the sponsor.
The regulation states that although the trust had multiple
classes, the classes are substantially equivalent to undivided
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interests in the asset pool coupled with a limited recourse
guarantee running from the sponsor to the senior certificate
holders. Therefore, the multiple classes are considered
incidental to the trust's purpose of facilitating direct
investment in the trust's assets, and the trust is a trust for
federal income tax purposes. Until the issuance of this Revenue
Ruling, the Service had always taken the position that retention
of the subordinated interest by the sponsor was necessary for a
transaction to qualify under the analysis set forth in the
example in the regulations.
We will keep you informed of further developments.
David J. Mangefrida Jr.
Assistant Counsel - Tax
Attachment