IRS Revenue Ruling
1997-3

Code Secs. 61, 851, 856, 895, 7701

<<FULL TEXT>>

26 C.F.R. 1.61-1: Gross Income.
(Also sections 851, 856, 895, 7701; 1.851-2, 1.856-2, 1.895-1,
301.7701-13A.)

SBA guaranteed payment rights; participating securities. The Small
Business Administration (SBA) is the primary obligor of the guaranteed
payment rights that are created under its participating security program
and investors in those rights are treated as owning SBA debt.


REV. RUL. 97-3

ISSUE

For federal tax purposes, is the Small Business Administration (SBA)
the primary obligor of certain guaranteed payment rights that are created
under its participating security program?


FACTS

The SBA is an independent agency of the United States. Its activities
include regulating and providing financial assistance to small business
investment companies (SBICs), which furnish venture capital to small
business concerns. One way SBICs raise money for investment is by issuing
participating securities to the SBA. See 15 U.S.C. sections 683 and 687(l)
(1994). Participating securities may take the form of preferred stock,
preferred limited partnership interests, or similar instruments. 15 U.S.C.
section 683(g) (1994).

Regardless of their form, or the rights they may provide under state
and local law, all participating securities share the following
characteristics. Every participating security entitles the SBA to both a
return of capital (Redemption Payments) and priority distributions that
equal a fixed percentage of the unreturned capital (Prioritized Payments).
Redemption Payments have to be made by the final due date, which in most
cases, is approximately 10 years from the day the participating security
is issued. Before the final due date, a SBIC may make Redemption Payments
at its discretion, or may be required to make Redemption Payments for
reasons such as its insolvency. Prioritized Payments are scheduled to be
made at least annually, but are due only to the extent that the SBIC has
sufficient profits. Any scheduled amount that goes unpaid accumulates.
Every participating security also entitles the SBA to receive a portion of
the SBIC's remaining profits (Profit Participation Payments) and gives the
SBA the right to bar any changes affecting its interests.

Once every quarter, the SBA acquires new participating securities and
assembles them into a pool to be securitized. Every security in a newly
formed pool has the same final due date for making Redemption Payments and
uses the same percentage for calculating Prioritized Payments. The
percentage used to calculate the Prioritized Payments is established with
reference to current interest rates.

To securitize a pool, the SBA assigns the Redemption Payments and.
Prioritized Payments to a group of underwriters and simultaneously enters
into a guarantee relating to the assigned payments (the Payment
Guarantee). All rights in the participating securities, other than the
Redemption Payments and Prioritized Payments, are retained by the SBA, and
the SBA has no duty to exercise them for anyone else's benefit. The
underwriters transfer the assigned payments and the Payment Guarantee to a
trust. In exchange, the underwriters receive a single class of marketable
trust certificates that in form evidence beneficial ownership of the
transferred assets. Proceeds from the underwriters' sale of the trust
certificates are paid to the SBICs whose participating securities make up
the pool.

Under the Payment Guarantee, the SBA must disburse quarterly the amount
by which (1) the Prioritized Payments made by the SBICs and available to
the trust fall short of (2) the Prioritized Payments that would be due if
Prioritized Payments had to be made regardless of financial condition and
were paid in quarterly installments rather than annually. 15 U.S.C.
section 683(g) (1994). Thus, if a SBIC's profits are so low that the SBIC
has no obligation to make a Prioritized Payment, the SBA nevertheless has
to pay, in quarterly installments, the amount that would be owed if the
SBIC's profits were unlimited. Making a payment in this case does not
entitle the SBA to seek immediate restitution from the SBIC. Instead, the
SBA has to recover the payment from whatever future Prioritized Payments
the SBIC may generate.

The Payment Guarantee also obligates the SBA to pay any shortfall in a
pool's Redemption Payments. The SBA, therefore, has to make up any
Redemption Payment that a SBIC fails to pay on the final due date or
cannot pay when forced to redeem a participating security (for instance,
in the case of insolvency or commencement of receivership proceedings).
Under these circumstances, the right to receive the Redemption Payment
from the SBIC is released by the trust in favor of the SBA.

By the terms of the Payment Guarantee, the obligations of the SBA are
unconditional and must be performed despite any legal or equitable
defense. Each time a new pool is created, the SBA will reasonably expect
to disburse and not recover, during the pool's first three years, an
amount exceeding 15 percent of the Prioritized Payments that would be due
on the participating securities in the pool if Prioritized Payments had to
be made regardless of financial condition and were paid in quarterly
installments rather than annually. The Payment Guarantee cannot be
transferred separately from the rights to the Redemption Payments and
Prioritized Payments.

The trust that holds the Payment Guarantee and the rights to the
Redemption Payments and Prioritized Payments is authorized by statute, is
U.S.C. section 6871(a) (1994), and governed by an agreement among the SBA,
the SBA's fiscal agent, and an independent trustee. These parties may
amend the agreement without the consent of the certificate holders,
provided the amendment does not adversely affect payments on the
certificates.

In form, each trust certificate represents a fractional undivided
ownership interest in the transferred assets. The SBA guarantees (the
Passthrough Guarantee) that the certificate holders will receive timely an
amount equal to their proportionate share of all amounts received by the
trust. 15 U.S.C. section 6871(b) (1994). The Passthrough Guarantee is
enforceable regardless of the defenses available to the SBICs or the
trustee. Although the certificate holders can enforce the Passthrough
Guarantee, they cannot enforce any obligation of the SBICs. Specifically,
the certificate holders have no right to enforce the Prioritized Payments
or Redemption Payments, and the underlying SBICs owe no duty to the
certificate holders.

The trustee has no duty or authority to enforce collection of the trust
assets other than the Payment Guarantee. Instead, the SBA services (at its
expense) the Redemption Payments and Prioritized Payments and has the sole
right to take action and assert claims with respect to the Redemption
Payments and Prioritized Payments. As servicer, the SBA can waive or agree
to amend any term of any participating security; those modifications,
however, cannot decrease or defer the aggregate payments to the trust. No
federal or state law may limit the exercise by the SBA of its ownership
rights in the participating securities. 15 U.S.C. section 687l(e)(2)
(1994).

Because the SBA forms a new pool of participating securities each
quarter, several pools may exist at any time. The SBA has the right (but
not the obligation) to replace Redemption Payments and Prioritized
Payments due on one pool with Redemption Payments and Prioritized Payments
due on another. Specifically, if the SBA believes a participating security
in a pool is about to make a Redemption Payment, the SBA can exchange the
rights to all or part of that Redemption Payment (and related Prioritized
Payments) for the rights to all or part of the Redemption Payments and
Prioritized Payments due on participating securities in other pools.

The SBA can exercise the right of substitution at any time provided
three conditions are met. These conditions ensure an adequate match
between the payments relinquished on a redeeming security and the payments
to be received in exchange from any "replacement" securities. First, the
sum of the Redemption Payments to be received with respect to the
replacement securities must equal the amount of the Redemption Payment
relinquished with respect to the redeeming security. Second, the final due
date for each replacement security must be no later than the final due
date for the redeeming security. Third, the percentage used for
calculating the Prioritized Payments on each replacement security must be
no less than the percentage used for calculating the Prioritized Payments
on the redeeming security.

There are common situations in which the SBA can benefit from using the
substitution power. For example, if a pool holds a 6 percent security that
is about to be redeemed, the SBA can replace it with an 8 percent security
from an older pool. Certificate holders in the older pool, after receiving
the Redemption Payment from the 6 percent security, will no longer be
entitled to Prioritized Payments on the redeemed amount. Certificate
holders in the 6 percent pool will receive Prioritized Payments from the 8
percent security, but only at a 6 percent rate. Consequently, the exchange
will advance the termination of the older, higher interest rate pool, and
allow the SBA to retain the extra 2 percent of Prioritized Payments that
are not required to service the 6 percent pool.


LAW

The economic substance of a transaction generally governs its federal
tax consequences. Gregory v. Helvering, 293 U.S. 465 (1935), XIV-1 C.B.
193. Affixing a label to an undertaking (for example, referring to an
arrangement as a "guarantee") does not alone decide its character. Sun Oil
Co. v. Commissioner, 562 F.2d 258, 263 (3d Cir. 1977); Oesterreich v.
Commissioner, 226 F.2d 798, 801-02 (9th Cir. 1955); Boulez v.
Commissioner, 83 T.C. 584, 591 (1984); see also Commissioner v. P.G. Lake,
Inc., 356 U.S. 260 (1958), 1958-1 C.B. 516.

A guarantee of an instrument is a secondary and collateral promise to
pay the amounts due under the instrument in the event the primary obligor
(ordinarily the issuer) defaults. Zappo v. Commissioner, 81 T.C. 87-88
(1983); Perry v. Commissioner, 47 T.C. 159, 163 (1966). The Commissioner
may recharacterize any transaction that has the preceding attributes in
appearance but not in substance. See Estate of Durkin v. Commissioner, 99
T.C. 561, 571 (1992). How the transaction may be rechacterized depends on
the facts, including the terms of the "guarantee" and any related
agreements and the circumstances existing at the time the "guarantee" is
made.

For example, at the time a taxpayer "guarantees" an instrument, the
finances of the issuer may be so precarious that the taxpayer (rather than
the issuer) is expected to pay the instrument. Under such facts, the
taxpayer may be, in substance, accepting primary (rather than secondary)
responsibility for the instrument. Lang v. Commissioner, 32 B.T.A. 522
(1935); see Rev. Rul. 94-42, 1994-2 C.B. 15. As another example, under the
terms of a "guarantee" and any related agreements, a taxpayer may have to
pay regardless of any default on the "guaranteed" instrument and may enjoy
beneficial ownership of the instrument. Beneficial ownership may be
evidenced by, among other things, a power in the taxpayer to replace the
instrument or to exercise for its own advantage any privileges inherent in
the instrument. See Schoellkopf v. Commissioner, 32 B.T.A. 88 (1935); cf.
Rev. Rul. 77-137, 1977-1 C.B. 178. Under such facts, the taxpayer may be,
in substance, issuing its own primary obligation and using the
"guaranteed" instrument to secure that obligation. Rev. Rul. 78-118,
1978-1 C.B. 219; see Schoellkopf v. Commissioner. Different facts may
support other characterizations. No single fact is conclusive, and all
aspects of a transaction must be considered to determine its substance.


ANALYSIS

The trust holds a group of inseparable rights consisting of the rights
to the Redemption Payments, the Prioritized Payments, and the amounts paid
under the Payment Guarantee. Based on all of the facts and circumstances,
this group of rights (the Guaranteed Payment Rights) constitutes, in
substance, a primary obligation of the SBA. It does not represent an
ownership interest in SBIC securities backed by an SBA guarantee. Among
the reasons for this conclusion are not only the differences between the
payment obligations of the SBA and the payment obligations of the SBICs
but also the continuing interest of the SBA in the participating
securities.

The payment obligations of the SBA and the SBICs differ in that the SBA
has to make payments even if the SBICs are not in default. A SBIC has to
make a Prioritized Payment only if it has sufficient profits, but the SBA
must disburse an amount equivalent to that Prioritized Payment in all
events. Also, a SBIC has to make Prioritized Payments only on an annual
basis, but the SBA must make payments quarterly. These differences are
more than a matter of form. Each time a new pool is created, the SBA will
reasonably expect to disburse and not recover, during the pool's first
three years, an amount exceeding 15 percent of the Prioritized Payments
that would be due on the participating securities in the pool if
Prioritized Payments had to be made regardless of financial condition and
were paid in quarterly installments rather than annually.

In addition, the SBA retains beneficial ownership of the participating
securities. Although, in form, the rights to the Redemption Payments and
Prioritized Payments are transferred to the trust, neither the trust nor
the certificate holders enjoy any rights of beneficial ownership in the
participating securities. No federal or state law can limit the exercise
of the SBA's ownership rights in the participating securities, and the SBA
makes no promise to exercise these rights for the trust's benefit. 15
U.S.C. section 687l(e)(2) (1994). The SBA never transfers its interests in
the Profit Participation Payments and continues to service (at its
expense) the Redemption Payments and Prioritized Payments. Moreover,
neither the trustee nor the certificate holders can force the SBICs to
make these payments. The SBA enjoys a right to replace Redemption Payments
and Prioritized Payments due on one pool with Redemption Payments and
Prioritized Payments due on another. This right allows the SBA to exercise
control over a participating security for its own rather than the
certificate holders' benefit. It also demonstrates that a certificate does
not represent an interest in any identifiable participating security.


HOLDING

For federal tax purposes, the SBA is the primary obligor of the
Guaranteed Payment Rights created under its participating security
program, and the trust certificate holders are treated as owning
indebtedness of the SBA.

This revenue ruling is predicated on the law governing the SBA
participating security program as of December 24, 1996. Therefore, before
relying on this revenue ruling, taxpayers, Service personnel, and others
are cautioned to determine whether the law referred to has materially
changed since that date. See section 7.01(6), Rev. Proc. 89-14, 1989-1
C.B. 814.


DRAFTING INFORMATION

The principal author of this revenue ruling is Kenneth Christman of the
Office of Assistant Chief Counsel (Financial Institutions & Products). For
further information regarding this revenue ruling contact Mr. Christman on
(202) 622-3950 (not a toll-free call).

<<END RULING>>

TO CONTACT
DON FITCH CPA

Phone Don Fitch CPA Toll Free at (877)CPA-Help or (877)272-4357 or on our Direct Line at (760)674-1722.