United States

Proposed regulations would update "registered form" debt rules

Intended to provide modernization, based on current market practices

TAX ALERT  | 

Federal tax rules prohibit the deduction of interest on “registration-required obligations” unless they are in “registered form.” Similarly, holders of these debt instruments are generally permitted to deduct losses on disposition of the instruments, only if the obligations are in registered form.

Broadly speaking, the registered form rules enable the tracking of interest income to the debt holders who receive it. Registered form for a debt instrument is also required for a foreign holder of a U.S. debt instrument to benefit from the portfolio interest exemption from U.S. withholding tax on interest payments. 

Treasury and IRS have issued proposed regulations (REG-125374-16) intended to modernize the definitions of “registered form” and “registration-required obligation.”

Proposed “registration-required obligation” definition

The proposed definition of “registration-required obligation” would follow along the lines set by another tax definition for debt instruments, resulting in a clearer rule than the one currently in effect. If the new regulations are finalized as proposed, registration-required obligations would be those “traded on an established market” within the meaning of Regulation §1.1273-2(f). This includes exchange-traded debt and also includes debt for which price quotes are available on subscription-based debt pricing services such as those offered by Markit and Thomson Reuters LPC (formerly known as Loan Pricing Corporation). For debt instruments with a stated principal amount of $100 million or less, there is an exception from this “traded on an established market” definition; however, this exception wouldn’t apply to the newly proposed definition of “registration-required obligation.” References to debt pricing services, which are widely-used by debt traders, represent an example of the modernization the proposed regulations are intended to provide.

Proposed “registered form” definition

The proposed definition of “registered form” is also intended to refer to current business practices of debt agents and clearing organizations. Under the proposed regulations, an obligation would be considered to be in registered form if it is transferable through a book entry system. In addition, an obligation represented by a physical certificate in bearer form will be considered to be in registered form if the certificate is effectively immobilized, i.e. cannot be exchanged without a clearing or similar organization making record of the transfer. The proposed regulations changes to existing regulations are generally consistent with rules previously set out by the IRS in Notice 2012-20.

Pass-through certificates and participations

Of interest to investors, custodians and sponsors of debt investment vehicles, the proposed regulations also include rules addressing pass-through certificates. Pass-through certificates generally evidence partial ownership of an interest in a pool of debt instruments.

In many cases the entity issuing pass-through certificates is a grantor trust and the certificate holders are treated for federal income tax purposes as if they held the underlying debt instruments directly. However, in cases where the entity issuing the pass-through certificates may acquire additional assets after its formation or dispose of assets from time to time, the entity generally will not be classified as a grantor trust for federal tax purposes.

Failure to qualify as a grantor trust does not preclude an entity from issuing pass-through certificates, but the current regulations specifically address pass-through certificates issued by grantor trusts. The proposed regulations would accordingly amend the definition of a pass-through certificate to expressly provide that pass-through certificates may be issued by entities that are partnerships or disregarded for federal tax purposes.

Potential collateral effect of the proposed regulations

The registered form rules mentioned above generally arose in 1982 when Congress enacted the Tax Equity and Fiscal Responsibility Act (TEFRA), and in some cases, arose after 1982 and expressly refer to the TEFRA rules enacted in 1982. The TEFRA registered form rules were intended to result in the replacement of bearer debt with debt in registered form because payments on the latter are much easier to track.

Another much older rule also refers to “registered form” – the definition of a “security” in section 165(g)(2) of the Tax Code. This older rule is important for taxpayers seeking to claim ordinary bad debt deductions. A debt that is issued by a corporation is a security under section 165(g)(2) if it is in registered form. A bad debt deduction can only qualify for ordinary deduction treatment (rather than capital loss treatment) if the debt in question is not a security under this definition. Thus, the broader the definition of “registered form” is for purposes of this “security” definition; the narrower the circumstances would support an ordinary bad debt deduction, which often is much more valuable than a capital loss.

The current registered form regulations were issued with a preamble stating that they apply for purposes of the TEFRA provisions, (T.D. 7852, (Nov. 5, 1982)). Nonetheless, some tax advisors look to the current regulations as guidance for purposes of the bad debt deduction rule. Neither the proposed regulations, nor their preamble, contain any mention of the bad debt deduction rule or any statement restricting the intended scope of the proposed regulations’ definition of “registered form.” As a result, if the proposed regulations are adopted as proposed, it is possible that they could have the collateral, taxpayer-unfavorable, result of narrowing the circumstances in which taxpayers may claim ordinary bad debt deductions.

Conclusion

The proposed changes would generally modernize and clarify the current rules for registration-required obligations. In addition, taxpayers that are investors, sponsors or custodians with respect to certain debt investment vehicles should appreciate the proposal regarding pass-through certificates. The proposal’s potential effect on the bad debt rules, however, is uncertain and may be unfavorable to taxpayers.

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