This document contains amendments to 26 CFR part 1 under sections 860A, 860G(b), 863, 1441, and 1442 of the Internal Revenue Code (Code). Under section 860C(a)(1), in general, a holder of a REMIC residual interest must take into account the holder’s daily portion of the taxable income or net loss of the REMIC for each day of the taxable year on which the holder held the interest. Thus, a residual interest holder generally is taxable currently on the taxable income or net loss of the REMIC without regard to whether or when the REMIC makes distributions. Section 860G(b) provides an exception to this general rule in section 860C for the timing of income attributable to the ownership of a REMIC residual interest. Under this exception, for purposes of sections 871(a), 881, 1441, and 1442, if amounts are includible in the income of a holder of a REMIC residual interest that is a nonresident alien individual or a foreign corporation, the amounts are taken into account only when paid or distributed to the foreign holder, or when the interest is disposed of.

In its earlier years, a REMIC may accrue and recognize more taxable interest income from the mortgages that it holds than it accrues and deducts as interest on the regular interests that it has issued. This produces net income for the REMIC and thus for the holder of the REMIC’s residual interest. Many REMICs are structured so that the REMIC uses all, or substantially all, of its cash flow to pay expenses and to pay principal and interest on regular interests (effectively using a portion of interest receipts to pay principal or other nondeductible items). Such a REMIC will make little or no distributions to the holders of the residual interest in the REMIC, and each holder will incur tax liabilities with respect to its share of the REMIC’s net income in an amount that exceeds the holder’s economic return.

In addition, all or substantially all of the income attributable to holding the residual interest will be subject to special rules relating to excess inclusions. To ensure that the income will be taxable in all events, these rules, among other things, prevent the use of net operating losses to offset the excess inclusions, see section 860E, and preclude any exemption from, or reduction in, applicable withholding taxes, see section 860G(b)(2). Residual interests that entitle the holder to little or no distributions are commonly referred to as noneconomic REMIC residual interests, and persons acquiring those interests receive an inducement fee for becoming the holder and undertaking the associated tax payment responsibilities. Taxable income that must be recognized in excess of the economic income for a period is often called phantom income. In the case of a REMIC, the early phantom income is generally offset by matching deductions (generally called phantom losses) in later periods.

Consistent with the Congressional purpose of ensuring that excess inclusions of REMICs be subject to tax, §1.860E-1(c) of the Income Tax Regulations provides for disregarding transfers of noneconomic REMIC residual interests if a significant purpose of the transfer is avoiding assessment or collection of tax. In addition, §1.860G-3(a)(1) provides, “A transfer of a residual interest that has tax avoidance potential is disregarded for all Federal income tax purposes if the transferee is a foreign person.” Section 1.860G-3(a)(2) provides, “A residual interest has tax avoidance potential . . . unless, at the time of the transfer, the transferor reasonably expects that, for each excess inclusion, the REMIC will distribute to the transferee residual interest holder an amount that will equal at least 30 percent of the excess inclusion, and that each such amount will be distributed at or after the time at which the excess inclusion accrues and not later than the close of the calendar year following the calendar year of accrual.” Accordingly, foreign persons are generally precluded from becoming the direct holders of noneconomic residual interests.

“Where necessary or appropriate to prevent the avoidance of tax imposed by [chapter 1 of the Code],” section 860G(b) authorizes the adoption of regulations requiring REMIC net income inclusions of foreign holders of REMIC residual interests to be taken into account for purposes of sections 871(a), 881, 1441, and 1442 earlier than is provided in section 860G(b)(1). The legislative history of the Tax Reform Act of 1986 indicates that Congress intended that this regulatory authority may be exercised with respect to noneconomic residual interests. See 2 H.R. Rep. No. 841, 99^th Cong., 2d Sess. II-236 (1986) (referring to residual interests that do “not have significant value”).

The IRS and Treasury Department have become aware that noneconomic REMIC residual interests are being transferred to domestic partnerships that subsequently allocate the phantom income to foreign persons. If a partnership has no foreign partners at the time the partnership acquires a noneconomic REMIC residual interest, the person transferring the residual interest to the partnership may take the position that neither §1.860E-1(c) nor §1.860G-3 is applicable. In turn, the partnership may take the position, by applying the aggregate approach to the relation between a partnership and its partners, that foreign persons who later become partners hold the REMIC residual interest that had previously been acquired by the partnership. Based on the conclusion that the foreign partners are holders of the residual interest, the partnership may take the further position that, under section 860G(b), a withholding tax obligation on the partnership’s allocation to the foreign partner of income from the residual interest arises no sooner than the time when distributions on the residual interest are made by the REMIC (distributions that will almost never occur with a noneconomic residual) or when the interest is disposed of. Under this view, the foreign holder’s tax liability with respect to net income of the REMIC (including excess inclusions) would be deferred until disposition of the holder’s interest in the REMIC residual interest, including a disposition through termination of the REMIC, a disposition of the REMIC residual interest by the partnership, or a disposition of the partnership interest by the foreign partner.

The IRS and Treasury Department have concluded that, in order to achieve effective assessment and collection of U.S. tax on REMIC net income, including excess inclusion income, in furtherance of the congressional purpose referenced above and section 860E(a)(1), (b), and (e) and section 860G(b) of the Code, the time when foreign partners are required to account for REMIC net income should be accelerated. That is, for purposes of sections 871(a), 881, 1441, and 1442, the temporary regulations eliminate the deferral (relative to section 860C) that section 860G(b)(1) might otherwise prescribe. To prevent the adoption of similar schemes using real estate investment trusts, regulated investment companies, common trust funds, or subchapter T cooperative organizations, foreign persons to whom excess inclusion income is allocated by any of these other entities must account for REMIC excess inclusions on a similarly accelerated basis.

Several provisions of regulations under sections 1441 and 1442 are relevant to the taxation of REMIC net income inclusions (and particularly net income inclusions with respect to noneconomic REMIC residual interests) that are allocated to foreign persons. Under §1.1441-2(e), for purposes of section 1441 and 1442, a payment generally is considered made to a person if that person realizes income, whether or not the income results from an actual transfer of cash or other property. Under §1.1441-2(d)(1), however, if a withholding agent is not related to the recipient or beneficial owner, the withholding agent has an obligation to withhold only to the extent that, at any time between the date that the obligation to withhold would arise but for the provisions of §1.1441-2(d) and the due date for the filing of a return on Form 1042, “Annual Withholding Tax Return for U.S. Source Income of Foreign Persons,” (including extensions) for the year in which the payment occurs, the withholding agent has control over, or custody of money or property owned by the recipient or beneficial owner from which to withhold an amount and has knowledge of the facts that give rise to the payment. For this purpose, a withholding agent is related to the recipient or beneficial owner if it is related within the meaning of section 482. Section 1.1441-2(d)(1) further provides that the foregoing exception does not apply “to distributions with respect to stock or if the lack of control or custody of money or property owned by the recipient or beneficial owner from which to withhold is part of a prearranged plan known to the withholding agent to avoid withholding under sections 1441, 1442, or 1443.”

Under §1.1441-5(b)(2), a U.S. partnership is required to withhold under §1.1441-1 as a withholding agent on an amount subject to withholding (as defined in §1.1441-2(a)) that is includible in the gross income of a partner that is a foreign person. Except as provided in §1.1441-5(b)(2)(v) (which prevents a second withholding obligation from arising with respect to the actual distribution of income previously withheld upon as a distribution from a U.S. partnership or trust), a U.S. partnership is required to withhold when making any distributions that include amounts subject to withholding. To the extent a foreign partner’s distributive share of income subject to withholding has not actually been distributed to the foreign partner, the U.S. partnership must withhold on the foreign partner’s distributive share of the income on the earlier of the date that the statement on Form 1065, “U.S. Return of Partnership Income,” is mailed (or otherwise provided) to the partner or the due date for furnishing that statement.

Pursuant to the authority granted under section 860G(b), for purposes of sections 871(a), 881, 1441, and 1442, these temporary regulations generally require a foreign partner in a partnership holding one or more REMIC residual interests to take into account REMIC net income inclusions at the end of its taxable year (or on the last date of the taxable year of a partnership that allocates REMIC net income to the foreign partner). The temporary regulations require a foreign shareholder in a real estate investment trust or regulated investment company, a foreign participant in a common trust fund, or a foreign patron of a subchapter T cooperative organization to take into account excess inclusion income at the same time as other income from the entity.

The temporary regulations also provide that an excess inclusion is treated as income from sources within the United States. The Treasury Department and the IRS believe this treatment is appropriate because the inclusions are largely phantom income arising from the special provisions of the Code relating to REMICs and thus are unlikely to have tax significance outside the United States. The temporary regulations provide that, to the extent excess inclusions are taken into account with respect to a residual interest, net losses with respect to the residual interest are allocated and apportioned to the class and grouping(s) of gross income to which the excess inclusions were assigned.

The temporary regulations also provide that the exemption available under certain circumstances to certain withholding agents that do not have custody or control of money or property from which to satisfy a withholding obligation is not available in any case with respect to an excess inclusion subject to these rules. No inference is intended as to whether, for purposes of this exemption, any right, obligation, contract, or arrangement other than a REMIC residual interest constitutes property of a sort from which a withholding obligation may be satisfied.

The regulations regarding the timing of REMIC income inclusions apply to REMIC net income of a foreign person with respect to REMIC residual interests with respect to which the first REMIC net income allocation to the foreign person under section 860C occurs on or after August 1, 2006. The regulations regarding the source of excess inclusions are applicable for taxable years ending after August 1, 2006.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. These regulations are necessary to provide taxpayers with immediate guidance to discourage the overly aggressive interpretations being employed for the inappropriate avoidance of current income tax assessment or collection by foreign persons who are allocated income from REMIC residual interests. Accordingly, good cause is found for dispensing with notice and public comment pursuant to 5 U.S.C. 553(b)(B), and with a delayed effective date pursuant to 5 U.S.C. 553(d). For the applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) refer to the special analysis section of the preamble to the cross-referenced notice of proposed rulemaking published in this issue of the Bulletin. Pursuant to section 7805(f) of Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.860A-1 also issued under 26 U.S.C. 860G(b) and 860G(e).

Section 1.860A-1T also issued under 26 U.S.C. 860G(b) and 860G(e). * * *

Section 1.860G-3T also issued under 26 U.S.C. 860G(b) and 860G(e). * * *

Par. 2. Section 1.860A-0 is amended as follows:

1. Section 1.860A-1, paragraph (b)(5) is added.

2. Section 1.860A-1T is added.

3. Section 1.860G-3, paragraph (b) is revised.

4. Section 1.860G-3T is added.

The additions and revisions read as follows: