Tax News
Partnership Interest in A Scratch-and-Dent Distressed Debt Master Fund Qualifies as a “registered form obligation”
January 26, 2015
Administrative Actions
PLR 201504004 is a bit of an esoteric ruling. It deals with the narrow issue of the availability of the Reg. 1.871-14(a) portfolio interest exemption to funds that invest in distressed securities that are not in registered form. As a background, the portfolio interest exemption provides that the receipt of interest is not subject to tax in the hands of a nonresident investor if the obligation is in registered form. Most obligations are. However, there are number of distressed obligations that are not. One such type of obligation is a scratch-and-dent mortgage. These are mortgages with incurable defects such as missed payments. They would often require a renegotiation and modification of the debt, which in turn would pose a tax issue under the Reg. 1.1001-3 debt modification rules.

This was not the topic of this ruling, however. At issue here was whether these securities could qualify for "registered obligation" status if they were contributed to a trust controlled by a hedge fund. So, to go back to the original issue. What do you do if you are a distressed debt hedge fund that specializes in this type of a security that happens to not be in a registered form? Well, you try to please your investors and find a workaround under the portfolio exemption problem. This is what you do. You set up a standard master-feeder structure. The foreign investors run their investments through the foreign blocker feeder and then into the Master. The Master takes the money and buys the scratch-and-dent securities. Then the securities are dumped into a Trust. Both the Master and the Trust interests will be transferable only pursuant to the procedures described in Reg. 5f.103-1(c). Then you take the position that the exception in Reg. 1.163-5T(d)(1) applies to the interests in the Master and the Trust. This Regulation provides that an interest (a "pass-through certificate") in a grantor trust is considered to be an obligation in registered form if the pass-through certificate is in registered form "without regard to whether any obligation held by the fund or trust to which the pass-through certificate relates" is in registered form. In addition to grantor trusts, the rule also encompasses " similar evidence of interest in a similar pooled fund or pooled trust treated as a grantor trust."

What was the hedge fund’s issue here? Neither the Trust, nor the Master were treated as "grantor trusts." The Master was a partnership for Federal tax purposes. While the Trust was disregarded for tax purposes, for some reason not described in the ruling, it was not a grantor trust. So the question here was whether these types of interests would qualify for interest similar to a pooled trust treated as a grantor trust. The Regulations do not elaborate what "similar" is, but apparently the IRS thought that this Master and the Trust are "similar evidences of interest in a similar pooled fund" within the meaning of Reg. 1.163-5T(d)(1). Therefore the interests were to be considered obligations in registered form.

There are a few other notable things about the ruling. First, the IRS specifically did not rule whether interest paid by the Master or the Trust will qualify as portfolio interest for purposes of sections 871 and 881 of the Code. Presumably, this is the position that the hedge fund will be taking. Second, the IRS did not rule whether the Master will be engaged in a U.S. trade or business. The facts of the ruling specifically provide that an independent servicer will do all of the negotiation and modifications of the mortgages held by the Trust, which appears to be where the fund will hang its hat for the no U.S. trade or business position.

The ruling can be found here.

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Tags: distressed hedge fund, portfolio interest exemption, registered obligation