Background

Whether an obligation is issued in bearer or registered form has significant tax implications under numerous provisions of the Internal Revenue Code of 1986, as amended (the “Code”). For example, under Code Section 163(f) interest paid on a registration-required obligation is deductible by the issuer only if such obligation is in registered form. In addition, U.S.-source interest paid to a nonresident alien or foreign corporation may be exempt from U.S. gross withholding tax under the portfolio interest exemption of Code Sections 871(h) or 881(c) only if the obligation with respect to which the interest is paid is in registered form.

Registration-Required Obligation

A registration-required obligation is defined as any obligation other than an obligation which (i) is issued by a natural person; (ii) is not of a type offered to the public; or (iii) is issued with a maturity of not more than one year. The term “registration-required obligation” is relevant for several provisions of the Code which use the same or a similar definition.

Pass-Through Certificates

A typical pass-through certificate is an interest in an investment entity—usually a grantor trust—which holds an underlying pool of obligations such as mortgage loans. Current rules generally treat a pass-through certificate evidencing an interest in a pool of mortgage loans as a registration-required obligation if, standing alone, the certificate satisfies the definition of registration-required obligation. Moreover, interest paid on a pass-through certificate is eligible for the portfolio interest exemption if the pass-through certificate, standing alone, is in registered form.

Registered Form

Under current regulations an obligation is treated as in registered form if (i) the obligation is registered as to both principal and any stated interest with the issuer or its agent and any transfer of the obligation may be effected only by surrender of the old obligation and reissuance to the new holder; (ii) the right to principal and stated interest with respect to the obligation may be transferred only through a book entry system maintained by the issuer or its agent; or (iii) the obligation is registered as to both principal and stated interest with the issuer or its agent and may be transferred both by surrender and reissuance and through a book entry system.

Notices 2006-99 and 2012-20

Market practices have changed since the Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) issued regulations defining registered form. Today, obligations are often traded in fully dematerialized form without being represented by a physical certificate, and if the obligation is represented by a physical certificate it is generally a single global certificate that is immobilized in a clearing organization that handles the obligation as if it were fully dematerialized at issuance. To bring the rules in line with these practices, Treasury and the IRS issued Notice 2006-99 to provide that an obligation will be treated as in registered form if no physical certificate is issued and ownership interests in the obligation are represented only by book entries in a dematerialized book entry system, notwithstanding that beneficial owners can obtain physical certificates in bearer form upon the termination of the clearing organization without a successor. However, comments following Notice 2006-99 expressed concern that the reference to a “dematerialized book entry system” created uncertainty regarding obligations represented by an immobilized global certificate nominally in bearer form.

Responding to these concerns, Treasury and the IRS issued Notice 2012-20 to clarify that an obligation evidenced by a global certificate that is nominally in bearer form will be treated as issued in registered form if it is issued either through a dematerialized book entry system or through a clearing system in which the obligation is effectively immobilized. Notice 2012-20 went on to provide that an obligation will be effectively immobilized if (i) the obligation is represented by a global security in physical form that is issued to and held by a clearing organization under arrangements that generally prohibit the transfer of the global certificate, and (ii) beneficial interests in the underlying obligation are transferable only through a book entry system.

Proposed Regulations

On September 15, 2017, Treasury and the IRS issued proposed regulations (the “Proposed Regulations”) which amend and centralize the definitions of registration-required obligation and registered form and provide newly issued rules covering pass-through certificates.

Registration-Required Obligations

The Proposed Regulations clarify that an obligation is of a type offered to the public if it is traded on an established market. Under the Proposed Regulations, an obligation will be treated as being traded on an established market if it is publicly traded within the meaning of the original issue discount (“OID”) rules of Treasury Regulations Section 1.1273-2(f). Generally, a debt instrument is treated as publicly traded under the OID regulations if a sales price, firm quote, or indicative quote is provided in a medium which is available to issuers or participants in the debt markets.

Pass-Through Certificates

The definition of pass-through certificate is also amended by the Proposed Regulations to include certificates issued by entities other than a grantor trust, including partnerships or disregarded entities. The Proposed Regulations also allow issuers of pass-through certificates to vary the assets they hold or the sequence of payments to lenders. Furthermore, Treasury and the IRS believe that an arrangement that satisfies the definition of registration-required obligation should be treated the same as a pass-through certificate even if the arrangement only involves a single underlying obligation or co-ownership of one or more obligations. To this end, the Proposed Regulations replace the requirement that the investment vehicle issuing pass-through certificates hold a pool of loans with a requirement that the vehicle primarily hold debt instruments.

Registered Form

Consistent with Notice 2012-20, the Proposed Regulations amend the definition of registered form in several ways. First, an obligation is treated as in registered form if it is transferable in a book entry system, including a dematerialized book entry system, maintained by the issuer, its agent or a clearing organization. Likewise, an obligation represented by a physical global certificate in bearer form will be considered to be in registered form if the certificate is effectively immobilized. To be effectively immobilized, the global certificate must be issued to and held by a clearing organization under an arrangement that generally prohibits the transfer of the physical certificate and permits transfers of beneficial interests in the obligation only through a book entry system.

In addition, the Proposed Regulations provide that a holder of an obligation can obtain the physical certificate in bearer form without causing the obligation to fail to be treated as issued in registered form if (i) the clearing organization terminates without a successor, or (ii) the physical securities are issued upon a change in tax law that would be adverse to the issuer but for the issuance of the physical securities in bearer form.

Effective Date

The Proposed Regulations incorporating guidance described in Notice 2012-20 related to the definition of registered form apply to obligations issued after March 18, 2012. The Proposed Regulations related to pass-through certificates and registration-required obligations of a type offered to the public will apply only to obligations issued after the publication of final regulations.