Case 2: When the asset itself is transferred
U. S. taxation rules for securitization
Under the U.S. tax laws, the following situations may find taxation of SPVs:
• Grantor trust
• Owner trust
• REMIC
• FASIT (since deleted)
• Other entities
Grantor trusts
There are special tax rules for non-discretionary trusts that beneficially hold assets for the grantor, that is, the author of the trust. Here, the trustees hold the assets solely as per the direction of the grantor.
Sections 671 to 679 of the IRC contain provisions on grantor trusts. A grantor trust is charged to tax on so much of the interest as it does not convey to the beneficiaries. Sec. 671 provides that when the grantor or another person is deemed the “owner” of any portion of a trust, such an owner is then required to include in computing his or her taxable income those items of income, deductions and credits against tax of the trust that are attributable to that portion of the trust. Remaining items of income, deductions and credits against tax are taxed to the trust or beneficiary as applicable, in determining taxable income. The grantor is not treated as “owner” in respect of such a share of its income as it may have been already beneficially apportioned to the beneficiaries.
There are several restrictions on grantor trusts, such as restrictions on rever- sionary interests.
In pass-through securitization transactions, the holders of the pass-through certificates will be deemed to be the substantive owners of the trust, and so the income will be taxed in the hands of the investors rather than the trust itself. This is a completely see-through treatment; even the expenses of the trust are treated as expenses rateably apportioned among the investors. The pass-through certificates of Ginnie Mae, Fannie Mae and Freddie Mac qualify for grantor trust treatment, as per several rulings of the IRS.
Tax Issues in Securitization 747
There were several rulings of the revenue on whether senior/subordinate structures would qualify as pass-through certificates. One of these is Sears Regulations6in 1984. These regulations provided: “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. See Commissioner v. North American Bond trust, 122 F 2d 545 [4]-2 USTC 9644] (2d Cir. 1941) cert. Denied, 314 U.S. 701 (1942). An investment trust with a single class of ownership interest, representing undivided beneficial interest in the assets of the trust, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders. An investment trust with mul- tiple classes of ownership interests ordinarily will be classified as a business entity under 301.7701-2; however, an investment trust with multiple classes of ownership interests, in which there is no power under the trust agreement to vary the investment of the certificate holders, will be classified as a trust if the trust is formed to facilitate direct investment in the assets of the rust and the existence of multiple classes of ownership interests is incidental to that purpose.”
By way of an example, it said where there are two classes A and B paying sequentially, then the trust will not be regarded as a trust but as a business entity:
A corporation purchases a portfolio of residential mortgages and trans- fers the mortgages to a bank under a trust agreement. At the same time, the bank as trustee delivers to the corporation certificates evidencing rights to payments from the polled mortgages; the corporation sells the certificate to the public. The trustee holds legal title to the mortgages in the pool for the benefit of the certificate-holders but has no power to reinvest proceeds attributable to the mortgages in the pool or to vary investments in the pool in any other manner. There are two classes of cer- tificates. Holders of Class A certificates are entitled to all payment of mortgage principal, both scheduled and pre-paid, until their certificates are retired; holders of Class B certificates receive payments of principal only after all Class A certificates have been retired. The different rights of the Class A and Class B certificates serve to shift to the Holders of the Class A certificates, in addition to the earlier scheduled payments of principal, the risk that mortgages in the pool will be pre-paid so that the holders of the Class B certificates will have “call protection” (free- dom from premature termination of their interests on account of pre- payments). The trust thus serves to create investment interests with respect to the mortgages held by the trust that differ significantly from direct investment in the mortgages. As a consequence, the existence of multiple classes of trust ownership is not incidental to any purpose of the trust to facilitate direct investment and, accordingly, the trust is clas- sified as a business entity under 301.7701-2.
Notably, when a trust is taxed as a business entity, it is taxable in its own right, and not as a representative taxpayer.
Owner trusts
A pass-through certificate is a certificate of ownership interest. As the trust distributes all ownership of its assets by way of pass-through certificates, it is left with no ownership.
However, subsequent transactions such as CMOs see the trust issuing debt- type instruments. As the trust will raise funds by issuing debt, the trust will be treated as the owner of the property – thus, the concept of owner trust. An owner trust is taxed on the same basis as a partnership entity. That is, the tax it pays is on behalf of the partners.
REMIC rules
To encourage CMO structures, REMIC rules were specifically inserted. We have noted before7 the historical setting under which the REMIC law was passed. The basic purpose of the REMIC law is to shift the burden of taxation of the whole transaction on residual income class, discussed below. However, as the residual income class need not have any substantial amount or percent- age of investment in the whole structure, most REMICs have a nominal (say, US$100) worth of residual class, and the rest of the classes are treated as substantive debt of the REMIC.
What is a REMIC?
• Real estate mortgage investment conduits (REMICs) are securitization entities that come for special treatment under Federal tax laws. The REMIC rules are contained in sections 860A to 860O of IRS regulations and contain a way out for the pass-through rules under which securities with multiple payback periods could not have been issued and the certificates had to mirror the pay-in period of the collateral pool. Most U.S. RMBS transac- tions adopt either the pass-through or the REMIC status. CMOs are gener- ally structured for tax purposes as REMICs.
• A REMIC must buy only qualifying mortgages. Qualifying mortgages include obligations principally secured by an interest in real property, and includes pass-through certificates and interest in other REMICs. Amendments made in 2004, effective January 1, 2005, allowed REMICs to buy interests in reverse mortgages as well.
• A REMIC does not have to be a separate legal entity. It can simply be a section of the mortgage pool. So, under one legal entity, for example, under one trust, there can be more than one REMIC.
• The REMIC itself is a tax-transparent entity. There is no entity-level tax on the REMIC. Tax is imposed on the holders of interests in the REMIC.
REMIC interests
• Every REMIC must designate two classes of interests – regular and residual interests.
• Regular interests can be of more than one class, but residual interests can only have one class.
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• Regular interest is comparable to a conventional bond with a fixed principal and interest on a fixed or floating rate. A residual interest can have any characteristic.
• As residual interest in a REMIC can be of only one class, where the struc- turer desires to have various interests which cannot be characterized as regular interests, the REMIC is broken into several REMICs, one investing into the other. For instance, if the originator intends to strip interest above 8% in a mortgage pool, and also intends to sell an IO strip of 8%, the first REMIC will acquire the entire pool and sell uncertified interest of 8% in the mortgage pool, retaining the balance. The second REMIC will buy the 8%
interest and sell the PO portion and the IO portion separately.
Taxation of REMIC interest holders
• The broad principles of taxation of REMICs are as follows; the REMIC itself is not taxed, but the interest holders are.
• The entire income of the REMIC is taken as the income of the residual interest holders, and the interest paid on the regular interests is taken as if it were a deductible expense. In other words, the (total income of the REMIC – interest on regular interests) is allocated to the residual class holders as their income. As mentioned above, in view of any minimum amount of residual interest, this has the effect of treating almost the entire regular interest in the REMIC as a debt and achieving tax neutrality.
FASIT rules
The FASIT rules were inserted in 1996 to create tax-efficient securitization vehicles for non-MBS asset classes. These rules are contained in section 860H to 860L of the IRC. Regulations have also been framed, albeit after a gap of four years since the enactment of the law.
Repeal of FASIT rules
“(F)rom beginning to end, almost nothing relating to FASITs has been done right,” comment leading tax authors James M. Peaslee & David Z. Nirenberg.8 Enron had reportedly misused the FASIT tax exemption for several high coupon transactions. The Joint Committee on Taxation’s Enron report recom- mended repeal of FASIT exemption, and it was repealed effective January 1, 2005. Existing FASITs were grandfathered.
The discussion below applies only to the grandfathered vehicles.
Principles of FASIT taxation
The basic principles of FASIT taxation are:
• As in the case of a REMIC, a FASIT will not come for an entity-level tax, nor will it be taxed as a trust or partnership.
• FASIT has a single class of ownership interest and one or more classes of regular interests. The tax burden of the entire transaction is shouldered by the ownership class. The regular interests are treated as the debt of the FASIT and therefore the residual income taxable to the ownership interest is only the income that remains after paying all regular interests.
• FASITs are permitted to invest in fixed-rate debt instruments, specified floating-rate debt instruments, inflation-indexed debt instruments and credit card receivables. Additionally, FASITs may hold beneficial interests in, or coupon and principal strips created from, these types of instruments.
• As a structural difference between REMICs and FASITs, FASITs are con- solidated, for tax purposes with the holder of the ownership interest.
Therefore, there are conditions laid down as to who can be an eligible holder of ownership interest.
• The holder of ownership interest may be a single domestic taxable corporation.
• Gain on sale rules have been incorporated into FASIT regulations. Transfer of assets to a FASIT triggers recognition of gain on sale to the holder of ownership interests.
Other entities
As noted before, if an SPV is treated as a business entity, it will be taxed on income less expenses. The key consideration of distinction between debt and equity has already been noted before.
Thin capitalization rules and SPV taxation
Tax laws of many countries provide for thin capitalization rules. The intent of these provisions is that, generally speaking, expenses on servicing of debt are allowable as an expense. Serving of equity is taken as a distribution and not as an expense. Every business requires a certain degree of equity or risk capi- tal. However, with increasing sophistication of financial instruments, it is pos- sible to structure an instrument that looks like debt but has the economic impact of equity, such as a subordinated debt. This would have the effect of exhibiting a servicing, which is really a servicing of equity as that of debt, and so would make an unjustifiable claim for tax expenditure.
To counter the tendency, tax laws of many countries put in a thin capital- ization rule providing that if the entity is thinly capitalized (indicated mostly by the debt-to-equity ratio), then the servicing of debt, or a certain part of the debt, will not be allowed as an expenditure. For instance, see Division 820 of the Income Tax Assessment Act 1997 of Australia.
This existence of thin capitalization and loan relationships also suggests related party transactions, because a lender lending to a thinly capitalized entity under circumstances that are not commercially sustainable indicates an affiliation.
Tax Issues in Securitization 751
How does this rule affect SPVs? SPVs are, by their very constitutional feature, nominally capitalized. If thin capitalization rules are applied to SPVs, several transactions with the SPVs will be subject to transfer pricing rules or will lead to disqualification of expenses. The only way out of this seems to be specific exemption from thin capitalization rules. For instance, sec. 820.39 of the Income Tax Assessment Act 1997 of Australia provides an exemption from the thin capitalization rules to an SPV on satisfaction of certain conditions (primarily bankruptcy remoteness as per criteria of an international rating agency).
Taxation of SPVs where no specific provisions exist: India
In most countries, specific provisions on taxation of securitization transac- tions would not be in place. As a case to illustrate how SPVs would be taxed when tax laws are silent, we take up the case of India.
In India, an SPV may:
• Either be exempt from tax altogether;
• Or be taxed in a representative capacity;
• Or be taxed in an independent capacity.
The form of organization of the SPV does not matter; if the SPV is organized as a company, it might still be regarded as a trustee for investors. If it is orga- nized as a trust, it may still be taxed as an entity and not as a representative of the investors.
The broad principles for the three alternative taxing schemes are the same as discussed earlier. Specific reference to the rules is made below:
Non-discretionary trust treatment
Tax laws make a distinction between discretionary trusts and non-discre- tionary trusts. Non-discretionary trusts are similar to the U.S. concept of grantor trusts, where the trustees are simply fiduciaries and work under a pre-fixed formula. In non-discretionary trusts where the share of the benefi- ciaries to the income of the trust is well defined, the income of the beneficia- ries is determinate and ascertainable. In such cases, though the tax officer has a right to tax the trust in a representative capacity, such tax cannot be any dif- ferent from the taxability of the beneficiaries. Therefore, there is no motivation on the part of the tax officer to tax the trust.
The rules about discretionary trust taxation were laid down by the Supreme Court in its landmark ruling in CWT v. Trustees of H. E. H. Nizam’s Family (Remainder Wealth) Trust(1977) 108 ITR 555 (SC), holding that the principles of representative taxation apply only where the shares of beneficiaries are not determinate. In other words, a trust is by itself not a taxable entity in India; a trust merely comes for vicarious tax if the shares of the beneficiaries are not determinate. The rule of discretionary trusts was once again Commissioner Of Income-tax v.Kamalini Khatau 209 ITR 101 (SC):
“A discretionary trust is a trust whose income is not specifically receivable on behalf or for the behalf of any one person or wherein the individual shares of the beneficiaries are indeterminate or unknown. The rate of tax payable by trustees upon the income of a discretionary trust is that which would be paid upon such income by an association of persons. Where, however, such income or a part thereof is actually received by a benefi- ciary, tax shall be charged thereon at the rate applicable to the total income of the beneficiary if this benefits the Revenue.”
Representative capacity
Representative taxation arises only when one person receives income on behalf of others; if a person receives income on his own behalf, he cannot be charged to tax on a representative basis. Thus, if the SPV issues debt securi- ties that constitute obligations, the income it receives will be an income on its own behalf and not for investors, thus resulting in entity-level tax and not representative tax.
The following are the essential principles of representative tax:
1. All representative assessees shall be liable to the same duties, responsibil- ities and liabilities and the tax incidence upon him shall be as if the income were received by the beneficiary. [Sec. 161 (1A)]. Under this pro- vision, the SPV can be taxed for the income deemed to be received by the SPV on behalf of the several investors, but such tax will be revenue- neutral, since this amount of tax cannot exceed the tax individually payable by the beneficiaries on such income. Obviously therefore, the revenue will not resort to representative tax in such a case.
2. Exceptions to this rule are made in sec. 161 (1A), 164 (1), 164 A and 167B.
When the trust falls under any of these exceptions, its income shall be charged to tax at the maximum marginal rate, that is, at the maximum slab applicable to individuals.
One would think even if the trust were to fall under any of the exceptions mentioned above, yet the trust would anyway have nil income, as what the trust is deemed to receive is to be netted off by what the trust pays to the ben- eficiaries, and the net result is invariably zero. In this proposition, difficulties in actual administration might arise because the trust becomes a separate assessable entity and also that a revenue-minded tax officer may regard the income of the trust as income and the expense as the appropriation of such income and not an expense, and hence tax the whole of the receipt. To avoid tax at a maximum marginal rate, the trust must ensure it does not fall under the provisions of sec. 161 (1A), 164, 164 A and 167B.Sec. 161 (1A) applies if any part of the income deemed to be received by the trust comprises business income. If the trust is not actually engaged in business activity, but is merely holding property and issuing beneficial interest certificates, the trust is deemed to receive income only on behalf of the beneficiaries, who may be
Tax Issues in Securitization 753
treating the acquisition of receivables or income as business income. If any one of the participants in the scheme receives the income as business income, the revenue will thereby get the right to tax the trust to representative tax and at the maximum marginal rate. As this strange provision, inserted with anti- avoidance intent, is applicable, the trust must ensure that none of the partici- pants hold the investment in securitized receivables as a business investment.
Sec. 164 (1) applies where the shares of the beneficiaries in the income of the trust are not known. That is not the case here, as the shares of the investors are known by the amount of investment made by them. Proviso to sec. 164 (1) and sec. 167 B apply to associations of persons (AOPs). These provisions apply to AOPs whose members – any of them – have income above the maximum that is exempt from tax. The trust in the instant case cannot afford to omit from the investor base all persons having taxable incomes. Hence, it would be ridicu- lous to get caught in these provisions. There are two escapes to provisions of tax applicable as AOP: First, claim that the trust in the instant case is merely a grantor trust that does not have any common objective except that property is held on behalf of a group of persons for the sake of convenience. An associa- tion of persons has a community of objective, formed for carrying out such objective; there is no such common objective served by the trust, except of name lending to the group of participants. The second, care to be observed for escaping sec. 167B is to avoid the definition of “body of individuals.” If not an AOP, the trust could be regarded as a body of individuals. For this, the escape is simple: As a participant in the scheme, include a person who is not an indi- vidual (such as a company).
Admittedly, the set of provisions dealing with trusts and AOPs is quite com- plicated, and obviously not designed to deal with the kind of trusts the secu- ritization exercise is going to create. However, in respect of several venture capital funds, there have been rulings of the Authority for Advance Rulings holding the see-through of pass-through nature of the trust in situations where the trust is non-discretionary.
Entity-level tax
Adequate attention has not been given to circumstances in which some of the
“beneficial interest certificates” of the trust may be treated as debt for tax pur- poses, leaving the entire burden of tax on the residual certificates. While it is true that the income of the trust will be taxed in the hands of the beneficiaries where their shares are determinate, if the trust issues various classes and some classes have limited interest to claim payment, they may be regarded as debt.
The distinction between debt and equity, discussed at length earlier, will apply here; a beneficial interest is merely an interest to claim distribution, while a debt is a right to claim money. Beneficial interest is not an actionable claim but a mere equitable right. If the certificates issued by the trust create a right to claim money, it would be proper to construe them as debt rather than as beneficial certificates.