Rev. Rul. 79-251

ISSUE

Whether, under the circumstances described below, interest received by a Netherlands Antilles corporation from "pass-through" mortgage-backed certificates, guaranteed by the Government National Mortgage Association (GNMA), is exempt from federal income taxation pursuant to Article VIII(1) of the Income Tax Convention between the United States and the Netherlands as extended by protocol to the Netherlands Antilles.

FACTS

Taxpayer is a foreign corporation organized under the laws of the Netherland Antilles. Taxpayer is not engaged in a trade or business in the United States through a permanent establishment. Taxpayer is not entitled to any of the special tax benefits enumerated in Article I(1) of the protocol.

Taxpayer has purchased "fully-modified pass-through" mortgage backed certificates as described in Rev. Rul. 70-545, 1970-2 C.B. 7. These certificates are backed by a pool of federally underwritten residential mortgages and were issued by a savings and loan association (the issuer) engaged in the business of financing residential mortgages. The certificates were issued in registered serial form by the issuer in minimum denominations of $25,000. The certificates call for payment by the issuer to taxpayer of specified monthly installments of both principal and interest. In addition, the certificates provide for payment to the taxpayer of its proportionate share of mortgage prepayments or other early recoveries of principal. The scheduled monthly installments are based on the amortization schedules of each of the mortgages in the pool, but are made by the issuer to taxpayer irrespective of whether the mortgagors actually make the payments due on their loans. Timely payment of principal and interest to the taxpayer on these certificates has been guaranteed by the GNMA pursuant to section 306(g) of Title III of the National Housing Act, 12 U.S.C.A. section 1721(g). Section 306(g) provides that the full faith and credit of the United States is pledged to the payments of all amounts which may be required to be paid under any guarantee under this subsection. This GNMA guarantee was characterized by the Assistant Attorney General of the United States in an opinion dated December 12, 1969 as constituting a general obligation of the United States.

The certificates purchased by taxpayer are transferable and assignable upon the books of the issuer, who acts as a registrar. The history of this type of certificate reveals that it is a very marketable, highly liquid instrument. See Publication HUD-487-GNMA, "GNMA Mortgage-Backed Securities," (Dec. 1977), a pamphlet published by the Department of Housing and Urban Development to acquaint potential investors with the history of GNMA and the mortgaged-backed certificates program which it offers.

LAW AND ANALYSIS

Section 894(a) of the Internal Revenue Code of 1954 provides that income excluded from gross income under a treaty shall be exempt from federal income taxation.

Article VIII(1) of the 1948 Income Tax Convention (the Convention) between the United States and the Netherlands, T.D. 5778, 1950-1 C.B. 92, as extended to the Netherlands Antilles by the Protocol of June 15, 1955 T.D. 6153, 1955-2 C.B. 777 (the 1955 Protocol), and as modified and supplemented by the Protocol of October 23, 1963, 1965-1 C.B. 624, provides that interest (other than interest referred to in Article V) derived from sources within the United States by a resident or corporation of the Netherlands not engaged in trade or business in the United States through a permanent establishment, shall be exempt from United States tax.

Article V of the Convention provides that income of whatever nature derived from real property and interest from mortgages secured by real property shall be taxable only in the contracting state in which the real property is situated.

Section 505.304(b) of the regulations issued under the 1955 Protocol provides that:

Interest on bonds, securities, notes, debentures, or any other form of indebtedness, which is paid by a person other than an Antilles corporation and which is derived from sources within the United States on or after January 1, 1955, by a nonresident alien individual who is a resident of the Antilles or by an Antilles corporation, is exempt from United States tax under the provisions of Article VIII(1) of the convention if the alien or corporation at no time during the taxable year in which the interest is derived has engaged in a trade or business within the United States through a permanent establishment . . . This paragraph applies to interest on obligations of the United States and instrumentalities thereof. It does not apply to interest from mortgage notes (not including bonds) secured by real property . . .

Whether the interest received by the taxpayer on the certificates is exempt from federal income taxation under Article VIII(1) of the Convention and section 505.304(b) of the regulations is dependent on the certificates qualifying as "bonds" secured by real property. The exemption is not applicable under Article V of the Convention and section 505.304(b) of the regulations if the certificates are characterized as mortgage "notes" secured by real property.

In United States v. Leslie Salt Co., 350 U.S. 383 (1956) [Ct. D. 1972, 1956-1 C.B. 677], the Supreme Court in considering the applicability of a documentary stamp tax was faced with the question of whether the instruments at issue represented notes or bonds. The identifying characteristics of bonds, as enunciated in Leslie Salt, are their free marketability and their having been issued in a series in registered form. Conversely, the Supreme Court characterized notes by their lack of free marketability.

The certificates purchased by taxpayer are marketable, highly liquid investments and are issued in registered serial form. Accordingly, these certificates are characterized as "bonds" secured by real property.

HOLDING

Under the circumstances described above, interest received by a Netherlands Antilles corporation from "pass-through" mortgage-backed certificates, guaranteed by the GNMA, is exempt from federal income taxation pursuant to Article VIII(1) of the Income Tax Convention between the United States and the Netherlands as extended by protocol to the Netherlands Antilles.