To bring back liquidity and reduce uncertainty in non-economic residual interest (NER) trading in the real estate mortgage investment conduit (Remic) market, the Internal Revenue Service has issued alternative guidance to the safe harbor' rule in connection with transfers of NERs within Remics.
The guidance issued last week is an amendment to proposed changes to the safe harbor rule the IRS made in February, when it issued guidelines for financial asset securitization investment trusts (Fasits).
While Remic investors complained that the original formula for determining if the safe harbor was applicable was too strict of a guideline, the proposed amendment back in February chilled trading activity in the marketplace.
"Liquidity dried up in terms of being able to buy and sell residual interests and that, in turn, backed up into the Remic markets and had broader adverse consequences on trading activity," said George Miller, deputy general counsel of the Bond Market Association.
The new guidance, which is retroactive to Feb. 4, is expected to bring liquidity back to the Remic market, so that, if enacted, it would apply to all NER transfers going back to February.
The safe harbor exists because the IRS wants to ensure that whoever holds the residual interest is an organization that is capable of and intending to pay tax. The IRS does not want transferors or broker/dealers to act as transferors in a wide range of circumstances, and wants to be sure that transferors have some reasonable basis for concluding that the transfer is not being done with that intent. A formula is in place to determine that intent.
The problem with the original guidance was that is was "too rigid and too inflexible and wouldn't capture a range of other circumstances, facts and assumptions that might be entirely consistent with an intent and capability to pay all taxes due on that residual interest," Miller said.
The new guidance states that the safe harbor can be achieved by transferring the NER to a domestic C-corporation, a fully taxable corporate entity with gross assets of at least $100 million and net assets of at least $10 million.
A NER exists when there is no cash flow from the underlying assets that is being diverted to that residual interest; so it really is not going to generate any positive cash flow.
"We felt that was important because it gives people in the markets a way, other than through this formula, to still meet a safe harbor that is very objective and clear cut, and workable," Miller said.
The Association agrees with the new guidance for the safe harbor alternative the IRS passed down last week.
"[The IRS] has issued an alternative safe harbor that we think is going to be preferable and more desirable in many cases than relying upon the formula," Miller said.
"And that's helpful because it creates additional certainty and provides an alternative mechanism for people to satisfy their regulatory obligations. We believe that liquidity and legal certainty in market will be positively affected. We're pleased and happy they've issued this guidance because I think it is welcomed in the industry."