REVENUE RULE 92-32

1992-1 C.B. 434, 1992-18 I.R.B. 11.

Internal Revenue Service
Revenue Ruling

SENIOR/SUBORDINATED INVESTMENT TRUST; TRANSFER OF SUBORDINATED INTEREST

Published: April 17, 1992

Section 7701.  Definitions, 26 CFR 301.7701-4: Trusts

Senior/Subordinated investment trust; transfer of subordinated interest. A subordinated interest of a senior/subordinated investment trust may be transferred without causing the trust to be classified as an association, taxable as a corporation.

ISSUE

A sponsor formed an investment trust by transferring a pool of debt securities to a trustee in exchange for two classes of pass-through certificates, senior certificates and subordinated certificates. The sponsor sold both classes of certificates to investors. Does the sponsor's sale of the subordinated certificates affect the classification of the investment trust as a trust for Federal income tax purposes?

FACTS

Sponsor owns a pool of automobile installment sale contracts (hereinafter, "contracts"). Each contract in the pool is secured by an automobile, is fully self-amortizing, has a fixed interest rate, and provides for level monthly payments over its term.

Under the terms of a trust agreement, Sponsor created an investment trust by transferring the pool of contracts to a trustee in exchange for two classes of pass-through certificates: Senior Certificates and Subordinated Certificates. The certificates represent undivided beneficial ownership interests in the pooled contracts. The trustee holds legal title to the contracts for the benefit of the certificate holders but has no power to vary the investment of the certificate holders.

Holders of the Senior Certificates are, in the aggregate, entitled to receive monthly distributions consisting of 90 percent of all scheduled payments of principal and interest on the pooled contracts and 90 percent of all prepayments on those contracts. Holders of the Subordinated Certificates are, in the aggregate, entitled to receive monthly distributions consisting of the remaining 10 percent of the payments on the pooled contracts.

The terms of the Senior Certificates are identical to the terms of the Subordinated Certificates except that, if there is in any month a shortfall in payments on the pooled contracts due to defaults or delinquencies, the amount of that shortfall will first reduce the monthly distribution on the Subordinated Certificates. The monthly distribution on the Senior Certificates will be reduced only after the monthly distribution on the Subordinated Certificates has been reduced to zero by shortfalls.

Sponsor sold both the Senior Certificates and the Subordinated Certificates to investors.

LAW AND ANALYSIS

Section 301.7701-4(c)(1) of the Procedure and Administration Regulations provides, in part, that an investment trust that has multiple classes of ownership interests is ordinarily classified as an association or a partnership under section 301.7701-2. However, an investment trust that has multiple classes of ownership interests is classified as a trust for tax purposes if (1) there is no power under the trust agreement to vary the investment of the certificate holders, and (2) the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose.

Section 301.7701-4(c)(2) of the regulations, Example (2), describes a typical senior/subordinated mortgage pool arrangement. In that example, Corporation M originated mortgages secured by residential real estate and, under the terms of a trust agreement, transferred those mortgages to a trustee in exchange for Class C certificates and Class D certificates. The trustee held legal title to the mortgages for the benefit of the certificate holders but had no power to vary the investments in the pool. Class C certificate holders were entitled to receive 90 percent of the payments of principal and interest on the mortgages, and the Class D certificate holders were entitled to receive the other 10 percent. The two classes of certificates were identical except that, in the event of a default on the underlying mortgages, the payment rights of the Class D certificate holders were subordinated to the rights of the Class C certificate holders. Corporation M sold the Class C certificates to investors and retained the Class D certificates.

Example (2) states that the trust has multiple classes of ownership interests because of the greater security provided the Class C certificate holders. The example goes on to state, however, that the interests of the certificate holders are substantially equivalent to undivided interests in the pool of mortgages, coupled with a limited recourse guarantee running from Corporation M to the holders of the Class C certificates. Example (2) concludes that the existence of multiple classes of ownership interests is incidental to the trust's purpose of facilitating direct investment in the assets of the trust, and the trust is therefore classified as a trust for Federal income tax purposes.

The transaction described in this ruling is substantially identical in all material respects to the one described in Example (2), except that, here, Sponsor sold the Subordinated Certificates to investors, whereas the sponsor in Example (2) retained the subordinated certificates. Despite this difference, the analysis in Example (2) is applicable. Sponsor's sale of the Subordinated Certificates to third party investors is equivalent to Sponsor's sale of an undivided interest in the pool of contracts encumbered by the limited recourse guarantee made by Sponsor to the Senior Certificate holders. Sponsor's transfer of the Subordinated Certificates to investors transfers the burden of the limited recourse guarantee to those investors but does not alter the trust's purpose of facilitating direct investment in the trust's assets.

HOLDING

If a sponsor creates an investment trust otherwise meeting the requirements of section 301.7701-4(c)(1) of the regulations by transferring a pool of debt securities to a trustee in exchange for two classes of pass-through certificates, senior certificates and subordinated certificates, the sponsor's sale of the subordinated certificates to investors does not affect the classification of the investment trust as a trust for Federal income tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is Timothy P. Sebastian of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information concerning this revenue ruling contact Mr. Sebastian on (202) 566-3299 (not a toll free call).

Rev. Rul. 92-32, 1992-1 C.B. 434, 1992-18 I.R.B. 11.