Mortgage investment trust lacks power to vary investments

Plain-English summary

A statutory trust purchased residential mortgage loans, immediately exchanged them for mortgage-backed securities, transferred most of those securities to its sponsor, and retained an interest-only strip. It also held cash collateral, interest, and distribution accounts subject to narrow investment limits. The trust could not acquire other assets or use its accounts to pursue market gains, and permitted investments were limited to cash, qualifying demand deposits, and specified money market funds. The IRS concluded that these restrictions did not give the trust managerial power to take advantage of market fluctuations. Accordingly, the trust did not have a power to vary the certificate holders' investments under Treasury Regulation Section 301.7701-4(c).

Ruling snapshot

• Question: Did the trust's limited authority over an interest-only strip and cash accounts create a power to vary certificate holders' investments?
• Outcome: Approved. The trust would not have a power to vary if operated as represented.
• Key authorities: IRC § 7701(a)(3); Treas. Reg. § 301.7701-4(c); Rev. Rul. 75-192; Rev. Rul. 86-92; Rev. Rul. 2012-17

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201827002 Third Party Communication: None
Release Date: 7/6/2018 Date of Communication: Not Applicable
Index Number: 7701.03-00
Person To Contact:
----------------------------- -----------------, ID No. -------------
----------------------------------------------------- Telephone Number:
------------------------------- ----------------------
---------------------------------------------- Refer Reply To:
CC:FIP:B02
PLR-116460-16
Date:
March 16, 2018

Legend

Taxpayer = -------------------------------------------------------------------------------------
State A = ---------------
Sponsor = --------------------------
Date 1 = --------------
Date 2 = ----------------
Securitizer = -----------------
a = ----
b = ----
x = ----

Dear ---------------:

  This is in reply to a letter dated May 17, 2016, and supplemental submissions

requesting a ruling on behalf of Taxpayer. Taxpayer requests a ruling that it does not
have a power to vary its investments under § 301.7701-4(c) of the Procedure and
Administration Regulations.

                                                    FACTS

  Taxpayer is a statutory trust formed under the laws of State A. Sponsor

sponsored the formation of Taxpayer.

   On various dates (each date, a “Sale Date”) during a 90-day period between

Date 1 and Date 2 (the “Aggregation Period”) in connection with Taxpayer’s formation,
Taxpayer purchased residential mortgage loans (the “Mortgage Obligations”) from
Sponsor. Sponsor remains the servicer on the Mortgage Obligations sold to Taxpayer.
The Mortgage Obligations are mortgages evidenced by promissory notes or other
similar evidence of indebtedness, each of which is a first mortgage, deed of trust or

similar security instrument on residential property consisting of one-to-four family
dwelling units, individual condominium units or individual units in planned unit
developments. The aggregate Mortgage Obligations sold by Sponsor to Taxpayer
during the Aggregation Period comprise the “Mortgage Pool.”

   On each Sale Date, Taxpayer simultaneously sold the acquired Mortgage

Obligations to Securitizer. In exchange, Taxpayer received Securitizer-issued
mortgage-backed securities. Taxpayer then transferred most of the mortgage-backed
securities to Sponsor in a transaction disregarded for federal income tax purposes and
retained one mortgage-backed security representing a x basis point interest-only strip
(the “Retained I/O Strip”). Taxpayer represents that the Retained I/O Strip is not related
to any amounts received by Sponsor for normal mortgage servicing rights and that the
Retained I/O Strip qualifies to be treated as a stripped coupon under § 1286 of the
Internal Revenue Code.

   In addition, as part of the transactions with Securitizer, Taxpayer agreed to

provide collateral equal to a % of the outstanding principal balance on the Mortgage
Pool, for a period of b years. Taxpayer has deposited cash into the Cash Collateral
Account to satisfy this requirement. Taxpayer also holds two other cash accounts: the
Interest Account and the Distribution Account

    Under the terms of the trust agreement, Taxpayer is permitted to acquire and

hold the Retained I/O Strip, the Cash Collateral Account, the Interest Account, and the
Distribution Account. The Cash Collateral Account and the Interest Account may be
invested in cash, U.S. dollar denominated demand deposits held at US. financial
institutions that are member banks of the Federal Reserve System, and money market
funds described in Rev. Rul. 2012-17, 2012-25 I.R.B. 1018. The Distribution Account
will be funded by transfers from the Cash Collateral Account and the Interest Account.

    Taxpayer is not permitted to acquire any other assets. Taxpayer only has the

right to invest as described above and does not have the power to dispose, sell,
reinvest, purchase or vary the investments of Taxpayer in any manner not described
above.

                              LAW AND ANALYSIS

   Section 7701(a)(3) provides that the term “corporation” includes associations.

    Section 301.7701-4(c)(1) provides that an “investment trust” will not be classified

as a trust if there is a power under the trust agreement to vary the investment of the
certificate holders.

   In Commissioner v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941),

cert. denied, 314 U.S. 701 (1942), the court stated that a power to vary the investment

of the certificate holders exists if there is managerial power under the trust instrument
that enables a trust to take advantage of market variations to improve the investment of
the investors. The court held that a power to acquire new bonds upon the admission of
new investors, where existing investors would acquire a pro rata interest in the new
bonds, was a power to vary the investment of the existing investors, as the power
allowed the trustee to take advantage of market variations in a manner that could
improve the investment of the original investors.

   Although a trustee may not actually exercise all the powers and discretion

granted under the trust agreement, the parties are not at liberty to say that their purpose
was other or narrower than that which they formally set forth in the instrument under
which their activities were conducted. Helvering v. Coleman-Gilbert Associates, 296
U.S. 369, 374, (1935), XV-1 C.B. 261 (1936).

     In Rev. Rul. 75-192, 1975-1 C.B. 384, a trustee receives principal and interest

payments on a pool of mortgages. Under the trust agreement, the trustee will make
quarterly distributions of all principal and interest payments received to each investor in
proportion to its interest. During the period between quarterly distribution dates, the
trustee is required to invest cash on hand in short-term obligations of (or guaranteed by)
the United States (or any agency or instrumentality thereof) and in certificates of deposit
of any bank or trust company having a minimum stated surplus and capital. The trustee
is permitted to invest only in obligations maturing prior to the next distribution date and
is required to hold such obligations until maturity. All the proceeds received from the
mortgage payments along with the interest earned on these short-term investments and
deposits will be distributed to the investors quarterly. The trustee has no authority under
the trust agreement to purchase new securities or mortgages, or to make any other new
investments. The revenue ruling concludes that the requirements limit the trustee to a
fixed return similar to that earned on a bank account and eliminate any opportunity to
profit from market fluctuations.

   In Rev. Rul. 86-92, 1986-2 C.B. 214, a trust holds tax- exempt bonds and

contracts to purchase tax-exempt bonds. The contracts provide that the bonds must be
transferred to the trust within 90 days of the trust’s creation. If a bond is not transferred
for reasons beyond the control of the trustee or the trust’s sponsor, the sponsor has 20
days within which to transfer different bonds of substantially the same character and
quality. The revenue ruling concludes that neither the trustee nor the sponsor has a
power to take advantage of market variations to improve the investment of certificate
holders. The powers are incidental to the organization of the trust.

   In this case, Taxpayer has limited ability to alter the assets it holds. Taxpayer

may only hold the Retained I/O Strip, the Cash Collateral Account, the Interest Account,
and the Distribution Account. The Cash Collateral Account and the Interest Account
may only be invested in cash, U.S. dollar denominated demand deposits held at US.
financial institutions that are member banks of the Federal Reserve System, and money

market funds described in Rev. Rul. 2012-17. Because Taxpayer does not have the
discretion to make an investment decision to reinvest the Retained I/O Strip in other
assets and may only invest the Cash Collateral Account and the Interest Account in
assets similar to those described in Rev. Rul. 75-192, even if Taxpayer does change the
assets held by the Cash Collateral Account and the Interest Account, it is limited to a
return similar to that earned on a bank account and has eliminated any opportunity to
profit from market fluctuations. Therefore, Taxpayer does not have a managerial power
under the trust instrument that enables Taxpayer to take advantage of market variations
to improve the investment of the holders, and Taxpayer does not have a power to vary
the investment of the certificate holders under § 301.7701-4(c).

                               CONCLUSION:

   Based on the information submitted and representations made, we conclude that

the Trust, if operated in accordance with the above representations, will not have a
power to vary under § 301.7701-4(c).

                                Sincerely,



                                Pamela Lew
                                Senior Counsel, Branch 2
                                Office of Associate Chief Counsel
                                (Financial Institutions & Products)

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