The IRS recently released new guidance to encourage mutual funds (regulated investment companies, or RICs) to invest in public-private investment partnerships (PPIPs). PPIPs are being formed under the Troubled Asset Relief Program (TARP), authorized by the Emergency Economic Stabilization Act of 2008, to invest in certain commercial and non-agency residential mortgage-backed securities (Program MBS). Because the special tax rules governing the taxation of RICs could discourage their participation in PPIPs, the IRS issued Revenue Procedures 2009-38 and 2009-42 to indicate that it would apply these rules in a way favorable to RIC investment.

Revenue Procedure 2009-38

Revenue Procedure 2009-38, 2009-37 I.R.B. 362 (Sept. 14, 2009), encourages RIC investment in PPIPs by preventing the corporate taxation of PPIPs, or RICs investing in PPIPs, as taxable mortgage pools (TMPs). Under Section 7701(i) of the Internal Revenue Code, an entity is a TMP if (i) substantially all of the entity’s assets consist of debt obligations and more than 50 percent of these obligations are real estate mortgages, (ii) the entity has issued its own debt obligations with two or more maturities, and (iii) the payments the entity makes as a debtor are related to the payments the entity receives as a creditor. The intent of Section 7701(i) is to ensure that real estate mortgage investment conduits (REMICs) are the only passthrough entities that can issue MBS of more than one maturity. Passthrough treatment is statutorily limited because of the potential of mortgage pools to generate noneconomic income and losses by mismatching the yields to maturity of the instruments they issue with the yields to maturity of the MBS held in their portfolios. Because Section 7701(i)(2)(D) permits the IRS to treat equity interests that correspond to maturities of  MBS held in a pool as debt in determining TMP status, the TMP provisions could require not only the classification of PPIPs as TMPs (by reason of their holding Program MBS) but also the classification of RICs, or subentity asset pools within RICs, as TMPs (by reason of their holding equity interests in PPIPs).

Effective August 27, 2009, Revenue Procedure 2009-38 removes the potential application of the TMP provisions to (i) PPIPs that hold Program MBS when the U.S. government holds a "significant equity interest" in the PPIP, (ii) RICs and other entities (such as REITs) with substantially all their assets being PPIP equity interests or equity interests in intermediate investment entities (intermediate entities) that separately satisfy this "substantially all the assets" requirement,  and (iii) any subentity asset pools within RICs (or other entities) holding equity interests in PPIPs or in intermediate entities.

Revenue Procedure 2009-42

Revenue Procedure 2009-42, 2009-40 I.R.B. __ (Oct. 5, 2009), provides RICs investing in PPIPs with lookthrough treatment in testing whether such RICs satisfy the asset diversification requirement essential to the maintenance of their special tax status. The asset diversification requirement consists of two tests:

  • At the close of each quarter of the taxable year, at least 50 percent of the value of a RIC’s total assets must be represented by cash and cash items, U.S. government securities, securities of other RICs, and securities of other issuers, the last being limited, in respect to any one issuer, to an amount that does not exceed 5 percent of the value of the RIC’s assets and that does not represent more than 10 percent of the outstanding voting securities of such issuer.
  • No more than 25 percent of the value of a RIC’s total assets may be invested in the securities of any one issuer (other than U.S. government securities and securities of other RICs), of two or more issuers that the RIC controls and that are engaged in the same or similar trades or businesses, or, collectively, of certain qualified publicly traded partnerships. 

RICs investing exclusively in PPIPs might not be able to satisfy either of these tests if their investments were deemed to be made in the equity interests of PPIPs rather than in the underlying Program MBS. Although prior IRS guidance had provided asset lookthrough treatment for feeder funds in master-feeder fund structures and for certain tax-exempt bond partnerships, no published authority provides RICs with asset lookthrough treatment for partnership investments in general. Indeed, one could infer from the Code’s express extension of lookthrough treatment to partnership income in the case of the parallel, "good income" requirement for RIC qualification (Code Section 851(b)(2)) that lookthrough treatment was inapplicable in testing satisfaction of the asset diversification requirement.

To qualify for lookthrough treatment with respect to its PPIP investments, a RIC is required by Revenue Procedure 2009-42 to invest at least 70 percent of its original assets (including seed capital and net proceeds from an initial public offering) in PPIPs, and a RIC's allocable share of each item of a PPIP's income, gain, loss, deduction, and credit generally must be proportionate to the RIC's percentage ownership of the PPIP’s capital interests. If a RIC meets these requirements, it will be treated as if it directly owned a share of the Program MBS held by each PPIP in which it invests that is proportionate to its percentage ownership of the PPIP's capital interests.

Revenue Procedure 2009-42 is effective for asset diversification determinations made as of dates after September 9, 2009.

The Tax Group of Ballard Spahr LLP is able to assist taxpayers in developing comments on Revenue Procedures 2009-38 and 2009-42 and on the extension of  their lookthrough principles to other types of pooled investment vehicles.

Contact Information

Please contact Ballard Spahr Partner Wayne R. Strasbaugh, at 215.864.8328 or strasbaugh@ballardspahr.com, for additional information and assistance.


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