IRS cracks down on self-amortizing investments in conduit financing entities.

• Jurisdiction: United States
• Author: Josephs, Stuart R.
• Date: 01 May 1997

In Notice 97-21, the IRS noted that certain persons are engaging in multiple-party financing transactions designed to allow a person (the sponsor) to avoid tax on substantial amounts of income (or to shelter substantial amounts of other income), by using a conduit entity whose income tax treatment artificially allocates the conduit's income to participants not subject to Federal income tax.

Example: A corporate sponsor forms a real estate investment trust or a foreign corporation (the Company). The Company issues two classes of stock. The corporate sponsor holds substantially all of the Company's common stock. The other class (the fast-pay preferred stock) is held by persons not subject to Federal income tax (exempt participants). The fast-pay preferred stock has limited voting rights and provides for preferred "dividends" equal to 13% of the stock's issue price each year for 10 years.

The Company holds income-producing assets (such as one or more mortgage loans) that are the obligations of, or guaranteed by, the corporate sponsor or guaranteed by a Federal agency. At all times during the first 10 years after the fast-pay preferred stock is issued, the Company must invest in assets that will produce income and cash flows at least equal to 101% of the dividends payable on the fast-pay preferred. During the first 10 years, the Company also may make distributions on its common stock; however, it cannot distribute more than 105% of its income in any year. Accordingly, it is not permitted to make any distributions representing a meaningful return of initial investment to the common stock holders during the first 10 years.

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