by: William Levy,
Mayer, Brown & Platt, May 16, 1997
The Financial Asset Securitization Investment Trust (or "FASIT") is the tax law's newest creation intended to facilitate the securitization of debt obligations currently securitized through, among other vehicles, master trusts, grantor trusts, and the FASIT's mortgage-backed cousin, Real Estate Mortgage Investment Conduits ("REMICs"). The FASIT legislation will become effective on September 1, 1997.
The flexibility afforded through a FASIT, which is elective, may be, in the right circumstances, an attractive alternative to existing securitization vehicles. For example, the FASIT vehicle does not require a "frozen pool", but allows for revolving or periodic asset funding. Also, the FASIT legislation will facilitate issuances of securities not previously possible, including periodic issuances over the life of the FASIT vehicle, not just at initial funding. However, as more fully discussed in the succeeding portions of this memorandum, there are certain costs generally associated with the election and other negative features which will have to be weighed against the benefits of FASIT. First, the FASIT legislation contains special provisions that will often require comparatively onerous acceleration of tax gain upon transfer of assets to a FASIT. Second, the treatment of residual or equity-like income under the FASIT regime is fairly punitive, even by comparison to the REMIC (and related taxable mortgage pool) regime. Furthermore, several areas of uncertainty in the legislation have been left open, particularly in connection with the transition for pre-existing master trusts that might seek to elect FASIT for post-September 1, 1997, transactions. Absent clarification by the Treasury before then, there may be fewer opportunities to utilize a FASIT in the short term than has been expected.
Part I of this memorandum provides a general overview of the provisions of the new FASIT legislation including the various requirements for FASIT treatment and the federal income taxation of holders of interests issued by the FASIT. Part II discusses a number of issues left open in the legislation that merit the attention of Treasury. Finally, Part III describes some selective effects of FASITs on the securitization industry.
A FASIT may be any entity (such as a trust, corporation or partnership)1 that elects to be treated as a FASIT and that meets certain requirements regarding the composition of its assets and the interests that it issues.2 It is expected that the typical FASIT will take the form of a state law trust, and that its interests will take the form of trust certificates. However, upon the making of an election for FASIT treatment, the FASIT generally will not be treated as an entity for purposes of, and therefore will not be subject to, federal income tax.3 Instead, the FASIT sponsor will in effect be treated as if it directly owned the FASIT assets and issued the FASIT interests (i.e., the ownership and creation of a leveraged asset pool).4
The revolving aspects of the "debt-for-tax" master trust structure (utilized for securitization of credit card receivables and similar short-term instruments) was a model for the FASIT legislation. The "regular interests" issued by a FASIT will be treated as debt for federal income tax purposes.5 Thus, a FASIT will be able to issue lower-rated debt securities than those that can be issued by a master trust, ensuring wider marketability.6
However, in a political climate demanding, as a practical matter, revenue neutrality (or even revenue enhancement) for most legislation (no matter how benign its purpose), the FASIT legislation was required to be designed to at least offset the reduction of federal income tax revenues that would be projected to occur from the extension of tax-favored debt treatment to an additional category of instruments issued to investors. The FASIT legislation accomplishes this preservation of tax revenue primarily through two features. First, when assets are transferred to a FASIT, the FASIT's owner must mark the assets to market and recognize built-in gain.7 As described below, this built-in gain calculation will be based in many cases (other than those involving transfers of publicly-traded debt instruments) on seemingly inflated valuations of the assets.8 Second, the legislation essentially requires that the FASIT's ownership interest and any "high-yield" regular interests will be held solely by domestic corporate investors subject to federal income tax,9 and that such investors will not be able to offset any current deductions or net operating losses from other sources against income from such interests.10
General FASIT Requirements. The following requirements must be met for a pool of assets to qualify for FASIT treatment:
When such requirements are met, the entity will be treated as a FASIT for the taxable year of the election and all subsequent taxable years until the date such requirements are no longer met or the election is revoked (with the consent of the Internal Revenue Service).18
Gain on Transfer of Assets to a FASIT. As indicated above, when an asset is transferred to a FASIT by the holder of the ownership interest (i.e., the sponsor of the securitization), the holder will be required to recognize gain (but will not be permitted to recognize loss) equal to the difference between the value of the asset as determined under the FASIT rules and its adjusted basis to the holder prior to contribution.19 In the case of revolving accounts, each draw assigned under a pre-existing continuing assignment (as is customary, for example, in credit card or trade receivable securitizations), will constitute an additional transfer to the FASIT immediately after its origination under the account, and thus be subject to this mark-to-market gain provision.20
For purposes of the gain calculation, the value of debt instruments transferred to a FASIT that are traded on an established securities market is their fair market value.21 However, the value of transferred debt instruments that are not traded on an established securities market (e.g., credit card receivables, trade receivables, home equity loans, auto loan receivables, and many other assets that are typically the subject of securitization transactions) is the present value of the "reasonably expected payments" under such instrument determined (in a manner to be provided in regulations) using a discount rate equal to 120 percent of the applicable federal rate (a rate approximating yields on Treasury securities with similar maturities).22 Although the manner of determining reasonably expected payments is left to regulations, the FASIT legislative history makes clear that expected losses, prepayments, and reasonable costs of servicing are to be taken into account.23 Because 120 percent of the applicable federal rate will likely be lower than the expected net yield to the FASIT on such debt instruments,24 the value of such instruments under this methodology will likely exceed the sponsor's tax basis in the instrument (which is typically equal to par). Therefore, this mark-to-market provision may often have the effect of accelerating to the date of transfer to the FASIT income that would otherwise be recognized at a later time.25
The paradigm assets for securitization in a FASIT will likely be credit card receivables or similar short-lived assets (such as trade receivables having a tax basis equal to the total amount owed, and thus no built-in gain). In the case of credit card receivables or other short-lived built-in gain assets, the gain recognition rules could simply have the effect in many circumstances of accelerating income on the receivables that would otherwise be recognized within a period of a few months. The negative effect of taxable income acceleration in such circumstances may be outweighed by the significantly improved financing flexibility available through the FASIT provisions.
Although it is likely that the mechanism for mark-to-market acceleration upon transfer to a FASIT will be least desirable for longer-lived assets such as real estate mortgages, it is noteworthy that some real estate mortgage obligations will be considered to be traded on an established securities market for purposes of the FASIT calculation, such that any gain upon transfer would be based on "true" fair market value. Utilization of FASIT for such obligations will likely be attractive in circumstances where other vehicles (e.g., REMICs) do not provide adequate flexibility or are otherwise undesirable.
Under a special rule, any asset held by the holder of the FASIT ownership interest, or by a related person, that "supports" any interest in the FASIT will be treated as held by the FASIT and subject to the gain recognition rules described above.26 However, the legislation does not define when such assets will be considered to support an interest in the FASIT. Any support definition likely will include the typical reserve funds held outside the securitization vehicle (e.g., the master trust itself) that provide additional credit enhancement to investors. Because such reserve funds are generally funded at commencement of a securitization with cash or investments acquired at that time that are likely to be considered publicly traded or, in any event, of a low yield, utilization of a reserve fund in the FASIT context would not normally enhance the amount of up-front gain recognition.
Permitted FASIT Assets. Permitted assets, which generally must constitute substantially all of the FASIT's assets,27 include:
- Cash and cash equivalents. Bank deposits and other similar cash equivalents.28
- Debt Instruments. Instruments that are treated as debt for federal income tax purposes and that pay fixed or, with certain exceptions, variable rates, or are "interest-only" securities, but not debt instruments providing for contingent payments such as equity kickers.29 Thus, such instruments will not include true leases, but would include finance leases, those certificates issued by master trusts that are in substance debt for tax purposes, and certificates in grantor trusts representing ownership interests in debt instruments held by the trust. However, debt instruments issued by the holder of the ownership interest in the FASIT or a related person will not be permitted assets unless they are cash equivalents or other investments specified in regulations.30 Thus, assets such as bank deposits issued by the holder of the ownership interest may be treated as permitted assets.
- Certain Hedging Instruments. An asset which is an interest rate notional contract (or foreign currency notional contract), letter of credit, insurance, guarantee against payment defaults, or other similar instrument to the extent permitted in regulations.31 Any such asset must be "reasonably required" to guarantee or hedge against the FASIT's risks associated with being the obligor on interests issued by the FASIT.32
- Certain contract rights. Contract rights to acquire debt instruments or hedges described in the preceding two paragraphs.33
- Foreclosure Property. Certain foreclosure property (generally determined by reference to the REIT rules) acquired in connection with the default or imminent default of a debt instrument held by the FASIT.34
- Regular Interests. A regular interest in a REMIC or another FASIT.35 Thus, as with REMICs, FASITs may be tiered.
Interests issued by the FASIT. Interests issued by the FASIT must be either regular interests or the ownership interest.36 The ownership interest and regular interests are the interests designated as such and issued after the day designated as the first day of the FASIT's first taxable year (the "start-up day").37 The holder of the ownership interest, typically the sponsor of the FASIT, is required to treat all assets, liabilities and items of income, gain, deduction, loss and credit of the FASIT as its own.38 For this purpose, regular interests are treated as debt (for all income tax purposes), thus giving rise to an interest deduction.39
There are two categories of regular interests (both of which are treated as debt).40 An instrument will qualify under the first category if all the following requirements are met (in addition to the requirements regarding designation and issuance after the start-up day):
- It must entitle the holder to a specified principal amount (or similar amount), which may be paid contingent on the timing (but not the amount) of prepayments on debt instruments and income from permitted assets held by the FASIT.41
- It must provide for interest payments (or other similar amounts), if any, at a fixed rate, or, except to the extent otherwise provided in regulations, at variable rates permitted for REMIC regular interests.42
- Unless permitted by regulations, it must have a stated maturity, including renewal options, not greater than 30 years.43
- It must have an issue price not exceeding 125 percent of its stated principal amount.44
- Its yield to maturity must be less than 5 percentage points above the applicable federal rate based on the projected maturity for the regular interest.45
An instrument will qualify under the second category of regular interest ("high-yield" regular interests) if it meets all of the above-described requirements except any one or more of the following (i) non-contingent principal (paragraph (1)), (ii) not having an issue price which is excessive compared to stated principal amount (paragraph (4)) or (iii) excessive yield (paragraph (5)).46 In addition, a high-yield interest may have interest (or other similar amounts) consisting of a specified portion of the interest on permitted assets.47
Regular interests in this second, high-yield, category are subject to the tainted income and transfer restrictions described in the next heading below.48 High-yield interests include, for example, regular interests having both relatively high yields more resembling equity returns (i.e., a regular interest having a yield to maturity in excess of the applicable federal rate plus 5 percentage points) and "interest-only" regular interests.
Tax Treatment of Regular Interests. Regular interests are treated as debt instruments for all income tax purposes.49 The holder of any regular interest is required to use an accrual method of accounting in respect of interest income even if the holder is otherwise on the cash method.50 Any original issue discount on the interest is also subject to the prepayment assumption rules.51
The second category of regular interests (high-yield regular interests) are subject to restrictions on transfer that make them (like ownership interests) generally unmarketable to certain investors such as foreign or tax exempt entities (e.g., pension funds).52 More specifically, if a high-yield interest is transferred to any holder other than (i) an eligible corporation (a domestic corporation that is not exempt from federal income tax, and is not a RIC, REIT or cooperative), (ii) another FASIT or (iii) certain securities dealers purchasing for resale to customers, the transferor is treated as having retained the interest and must report on its federal income tax return any gross income of the actual holder with respect to such high-yield interest.53 Any original issuance of a high-yield interest to any such ineligible holder will be disregarded, thus having the same practical impact indirectly through disallowance of the related interest deduction to the holder of the ownership interest.
The statute provides that if the transferor of a high-yield regular interest obtains a statement from the transferee sworn under penalties of perjury to the effect that the transferee is an eligible corporation or a FASIT (similar to provisions applicable to transfers of REMIC residual interests), and the transferor has no actual knowledge that the statement is false, the transferor will not be required thereafter to include the income from the high-yield interest even though a subsequent transferee is an ineligible holder.54
In addition, the statute contains provisions designed to prevent the use of pass-through entities to indirectly create high-yield securities not subject to the above transfer provisions.55 If a pass-through entity (including a RIC, REIT, common trust fund, partnership or trust estate) issues any debt or equity interest which is "supported" by any regular interest in a FASIT and that has an original yield to maturity that is greater than both the yield of such regular interest and a yield equal to 5 percentage points above the applicable Federal rate, then the pass-through entity is potentially subject to a tax equal to the highest rate of corporate tax multiplied by the income of the holder of such debt or equity interest that is properly attributable to such regular interest.56 However, during the process of legislative enactment, it was recognized that the original version of this provision was unduly broad and could impair legitimate markets for a FASIT's untainted regular interests in inappropriate circumstances. Accordingly, a provision was added to the legislation to apply the tax to a pass-through entity only if an arrangement has as "a principal purpose" the avoidance of the rules relating to high yield regular interests.57
Inability of Holders of Ownership Interests and High-Yield Interests to Utilize NOLs or Other Unrelated Items against FASIT Inclusions. In addition to effectively requiring that ownership interests and high-yield interests be held by domestic corporations subject to federal income tax, the FASIT provisions also provide that holders may not use their income in respect of such interests to offset any deductions or losses (including net operating losses) not attributable to the FASIT.58 All members of a consolidated group are treated as a single taxpayer for purposes of this rule so that losses of one eligible member may not be used to offset income in respect of FASIT ownership interests and high-yield interests held by another member.59
Prohibited Transactions. Like the REMIC provisions, the FASIT legislation provides for a 100 percent tax on the net income from certain prohibited transactions.60 However, because the FASIT legislation creates a leveraged ownership form of taxation for the sponsor, the prohibited transaction tax falls on the holder of the FASIT's ownership interest and not on the FASIT itself.61
Prohibited transactions subject to tax include the following:
It is not clear when a FASIT would be considered to have originated a loan such that a prohibited transaction tax could apply. Presumably, impermissible origination could not be considered to have occurred merely because of immediate acquisition of a receivable following its origination (as is common in credit card master trusts) pursuant to a customary forward assignment agreement with the sponsor. It should be satisfactory that any profit associated with such origination is recognizable by the originator of the loan rather than the FASIT. Examples of such origination profit would include annual fees and similar amounts paid by credit card obligors that are not typically transferred to a credit card master trust but are instead retained by the originating sponsor.
The substitution of one debt instrument that is a permitted asset for another debt instrument that is a permitted asset will normally not be considered a prohibited disposition transaction.66 Although the exception apparently does not similarly apply to substitutions of permitted hedges or other permitted assets that are not debt instruments, this exception constitutes a significant expansion from the rules applicable to REMICs. Under the REMIC rules, qualified mortgages in general may only be exchanged without incurring prohibited transactions tax in the case of so-called "defective" qualified mortgages (e.g., nonconforming mortgages or mortgages in default), and then only if the exchange occurs within the first two years after the REMIC's start-up day.67 This rule can inadvertently result in prohibited transactions tax if the terms of a qualified mortgage are amended to the extent of creating an exchange of debt instruments for federal income tax purposes. In a FASIT, however, the exchange of debt instruments that are permitted assets may generally occur at any time.68 Thus, for example, amendments to the terms of a debt instrument held by the FASIT will not normally result in prohibited transactions tax, provided that the terms of the amended instrument continue to be those of a permitted asset.
In addition, the FASIT provisions provide that if the FASIT's assets over-collateralize its regular interests, debt instruments contributed by the holder of the ownership interest may generally be distributed to such holder in order to reduce such over-collateralization of the FASIT.69 This is also a significant expansion of the REMIC provisions which only permit the distribution to the sponsor of income with respect to over-collateralization, but do not permit the distribution of any qualified mortgages contributed by the sponsor that constitute any portion of that over-collateralization.
In addition to these exceptions, dispositions of permitted assets will not be considered prohibited transactions subject to tax if they occur in connection with the foreclosure, default or imminent default of a permitted asset, the bankruptcy or insolvency of the FASIT or a qualified liquidation of the FASIT.70 Dispositions of permitted assets will also be allowed without tax where required to prevent a default on a regular interest if the threatened default results from a default on one or more permitted assets.71 In addition, permitted assets may be sold without incurring prohibited transactions tax in order to facilitate a clean-up call or incident to the complete liquidation of any class of regular interests.72
Miscellaneous Provisions. Miscellaneous provisions of the FASIT legislation provide rules regarding (i) the applicability of wash sale principles to contemporaneous sales and purchases of ownership interests in a FASIT;73 (ii) the continued application of section 475 mark-to-market accounting to assets that had been subject to such provisions in the hands of the transferor of such assets to the FASIT;74 and (iii) treatment of FASIT regular interests as qualified mortgages for various purposes so long as at least 95 percent of the assets of the FASIT are, at all times, qualified real estate mortgages or qualified assets, respectively, under the relevant statutory provisions.75
II. FASIT Issues for Future Resolution
The FASIT legislation has a number of important provisions requiring regulation issuance before they can become operative. In addition, other important areas are ambiguous and require guidance. It is certain that at least some FASIT formal guidance must be issued before the September 1, 1997, effective date in order to prescribe the method for making the FASIT election.76 Such guidance will presumably cover some of the additional matters described below.
Effect of Recognition Provisions on Existing Trusts. The FASIT legislation is designed to allow a securitization entity (i.e., a master trust) in existence on September 1, 1997, to elect FASIT with respect to post-September 1 securitizations.77 Although a new entity could of course be established after September 1, this would generally impair the cross-pooling among serial transactions typically considered necessary for efficiency of credit card and other similar master trust securitizations. The FASIT legislation ostensibly provides a transition rule for a cross-pooled arrangement involving both pre-September 1 transactions and elective FASIT post-September 1 transactions.
Under the transition rule, gain with respect to a debt pool supporting the pre-September 1 transactions, and which at the time of a FASIT election is apparently deemed contributed to the FASIT (along with a debt pool to support the new FASIT issuance), is deferred until such old debt pool "ceases to be properly allocable to a pre-FASIT interest".78 A "pre-FASIT interest" is an interest that was issued before the start-up day (e.g., before September 1) other than an interest held by the owner of the ownership interest in the FASIT.79 The provision specifies that the determination regarding when property will cease to be properly allocable to a pre-FASIT interest will be determined in regulations.80 This grant of regulatory authority was based on the recognition by those involved in the legislative process that greater specificity was necessary in the context of revolving cross-pooled structures. The participants in the process were unable to develop more specific guidance on this issue despite extensive attention in the final stages prior to enactment.
Some specificity is attempted under the transition provisions in a rule providing that property will be treated as properly allocable to pre-FASIT interests, and thus not yet subject to the gain recognition rules, "if the fair market value of all such property does not exceed 107 percent of the aggregate principal amount of all outstanding pre-FASIT interests".81
The 107 percent rule was apparently intended to give some relief to existing credit card master trust securitizations that subsequently elect FASIT treatment (the industry standard for the sponsor piece of a master trust is typically about 7 percent). However, read literally, the ability of this 107 percent rule to provide meaningful relief is not readily apparent. For example, assume a pre-existing securitization holding $107 million of credit card receivables and having $100 million of investor certificates outstanding. Any newly transferred receivables upon issuance of additional investor interests in connection with a FASIT election would make the relief rule inapplicable.82 It is understood that such a literal, draconian interpretation of the 107 percent rule was not intended. However, it is also understood that relevant government personnel have some concern with any simple formula apportioning between the relative initial sizes of pre-FASIT and FASIT securities (under a more reasonable interpretation of the transition rule) to the extent that it would apply indefinitely to all future collateral originations in a cross-supported revolving structure typical of master trusts. Because the impact of the gain recognition provisions is such a critical factor in the decision whether to elect FASIT, formal guidance clarifying this transition rule for existing arrangements should be uppermost on Treasury's list of issues targeted for guidance.83
Existing Trusts and Pre-FASIT Regular Interests. As discussed above, the FASIT legislation appears to be generally designed to accommodate pre and post-September securitizations in the same cross-pooled master trust. However, additional issues arise with respect to "pre-FASIT interests". Any election of FASIT treatment for a post-September 1 securitization by a cross-pooled arrangement that has already implemented pre-September 1 transactions would appear to literally cause all securitizations to be in the FASIT and any "pre-FASIT interest" to be tested and treated as an interest in the FASIT under the general FASIT provisions. In many existing master trusts, for legitimate business reasons, interests that may be partnership interests for tax purposes have been issued (in addition to "debt-for-tax" investor interests). Any such interest would apparently (under this comprehensive FASIT entity concept) either be somehow converted into a debt instrument (if it could qualify as a regular interest) on account of any FASIT election, or would disqualify the FASIT (since a FASIT can only have interests which are regular interests, or the single ownership interest, typically held by the sponsor). Also, the legislation contains no exception for any pre-FASIT interest from the rule that the holder of a regular interest must report income on the accrual method. Although cash method holders of pre-existing master trust "debt-for-tax" securities are presumably rare, this appears to be an unintended effect.
In both cases above, the regulations should either provide that the pre-FASIT interests are grandfathered or furnish alternative relief.84
Scope of Guarantees and Hedges. The list of hedges and guarantees under the definition of permitted assets is by no means exhaustive. The statute enumerates only interest rate and currency, notional contracts (including swaps, caps, and floors), letters of credit, insurance and guarantees against payment defaults as permitted assets (and then only if reasonably required to guarantee or hedge against the FASIT's risks associated with being the obligor on interests issued by the FASIT).85 "[O]ther similar instrument[s]" will only be considered permitted assets if provided in regulations.86
Significantly, the instruments enumerated above as permissible hedges or guarantees are instruments traditionally used in securitization transactions to hedge credit, interest rate and currency risks. Those instruments would not, however, typically be expected to be used to provide protection in respect of the maturity of interests in a securitization vehicle. Nonetheless, one of the principal advantages of the FASIT legislation is that it will permit sponsors to tailor maturities of regular interests more flexibly than is possible in a REMIC or grantor trust. For example, a FASIT is not required to pay through to investors the proceeds of maturing debt instruments. Proceeds may be reinvested in additional debt instruments, thus providing the ability to give holders of regular interests prepayment protection. Conversely, a FASIT could issue additional regular interests at any time in order to redeem another outstanding class of regular interests, and thus regular interests could have maturities that pre-date the maturities of the FASIT's assets. There does not appear to be any significant policy reason why a FASIT should not be permitted to use any type of hedge to facilitate this flexibility in structuring maturities differing from the maturities of the FASIT's assets.
Arguably, the legislation lists relatively few types of hedging and guarantee instruments, not because it was intended that the scope of permissible hedging be narrow, but rather because the drafters thought it unnecessary to provide an exhaustive list. For example, one obvious hedge that should be permitted no less than a currency swap is a currency option, and yet options are not specifically enumerated as permissible hedges. In addition, the statute requires that instruments similar to hedges and guarantees that will be provided as permitted assets in regulations must guarantee or hedge against the FASIT's "risks associated with being an obligor on interests issued by the FASIT".87 This language is certainly broad enough to encompass hedges intended to facilitate targeted maturities for the FASIT's interests.
Contracts to acquire debt instruments -- which possibly could also be used as hedges -- are specifically listed in the legislation as permitted assets (i.e., they need not be described in regulations in order to constitute permitted assets).88 The extent to which an asset constitutes a contract to acquire a debt instrument is not, however, entirely clear. For example, it is not readily apparent whether an option would qualify as a contract to acquire a debt instrument. The provision may, perhaps, refer only to forward purchase contracts obligating the FASIT to purchase a debt instrument. Similarly, it is not clear whether a cash-settled forward contract or a forward contract on an index could be treated as within this rule.
Calculation of FASIT Mark-to-Market Gain. The statute provides that gain in connection with the transfer of non-publicly traded debt instruments to a FASIT will be calculated on the basis of the present value of "reasonably expected payments" determined in accordance with regulations.89 Presumably, those regulations will provide the parameters for the information sources for estimating prepayments, payment delinquencies and losses. However, it is uncertain what data will be permitted as a guide, including the scope and degree of seasoning for pools of the sponsor's debt obligations that can be utilized for guidance. Optimally, safe harbors could be provided based on rating agency assumptions utilized in a particular transaction or, where possible, based on objective industry criteria. The FASIT statute also extends regulatory authority to prescribe situations in which a discount rate other than 120 percent of the applicable federal rate would be used for purposes of valuing the expected cash flows.90 Although Treasury will presumably consider a discount rate more reflective of the yield curve for longer-lived debt instruments held by FASITs, this may not be an issue that can be expected to receive early attention in the guidance process.
Clarification of "Interests" in a FASIT. Because the issuance of an "interest" in a FASIT that does not qualify as a regular or ownership interest would disqualify an entity for FASIT status,91 it is important that certain rights to payments from a FASIT not be characterized as an interest in a FASIT. The FASIT legislation does not provide an indication of what rights to payments will not be considered an interest in a FASIT. By analogy to the REMIC provisions, however, it is expected that reasonable servicing fees, the right to payments of interest from debt instruments held by the FASIT that constitute "stripped coupons" (including certain excess servicing compensation), and certain customary reimbursement rights should be included in regulations as not constituting an interest in a FASIT.92 If such stripped coupons provide any credit enhancement to holders of regular interests in the FASIT, such stripped coupons likely, though, would be considered to support those interests and would therefore be subject to the gain recognition rule.93
Single Ownership Interest Requirement in Consolidated Groups. The FASIT legislation leaves for regulatory guidance the extent to which an exception may be made from the single owner rule for ownership interests held by members of the same consolidated group.94 It is understood there was some concern in the legislation process that an automatic rule allowing multiple group owners could somehow facilitate artificial shifting of income among group members. (Income shifting could result in tax avoidance among group members where, for example, a member or members were subject to loss carryforward limits because of a prior separate return history before being acquired by the group.) However, any opportunity for abuse appears quite limited and could seemingly be addressed with a simple anti-abuse rule or under traditional provisions allowing re-allocation of income among commonly controlled corporations.
Possible Provisions to Avert Effects of Certain FASIT Terminations. If a FASIT ownership interest is at any time after the start-up day transferred to an ineligible holder, or if the status of the holder subsequently changes such that the holder then fails to qualify as an eligible holder, the FASIT will cease to be treated as a FASIT, resulting in associated negative tax consequences.95 In addition to disqualification as a result of a voluntary event (e.g., transfer to an ineligible holder or the making of a subchapter S election by the original holder), the disqualification could conceivably occur as a result of an unintentional or involuntary event (i.e., transfer of the ownership interest from a bankruptcy estate to an ineligible holder).96
By contrast, the REMIC rules require only that the REMIC have "reasonable arrangements" designed to ensure that its residual interests are held only by certain qualified holders.97 Given the potential for significant adverse consequences that could result from an uncontrollable or unintentional FASIT termination, the Treasury should consider similar relief in the FASIT context.98
III. Selective Effects of FASIT on Securitizations
A sponsor considering using a FASIT for the securitization of debt instruments in place of the pre-existing available alternatives will need to weigh the potential economic benefits of the additional structuring flexibility afforded by the FASIT provisions with any additional costs associated with the acceleration of income inherent in the mark-to-market gain provisions, the inability to offset FASIT inclusions against the sponsor's unrelated deductions and losses, and similar restrictions affecting high yield regular interests.
Master Trust Securitizations. The FASIT will be a potentially attractive alternative to traditional master trust securitizations that are typically used for credit card and other short-lived receivables (or certain trade receivables that have no built-in gain). The flexibility afforded by the FASIT legislation will eliminate some of the constraints associated with master trusts. For example, because a master trust's interests are in the form of equity interests in a trust, those investor interests must generally be rated at least "A" in order to be treated as debt for federal income tax purposes. A FASIT, however, will be able to issue lower-rated regular interests that will automatically qualify as debt for federal income tax purposes. In addition, because a FASIT is not subject to an entity level of taxation, no transfer restrictions will need to be placed on such lower-rated regular interests in order to ensure that the trust is not treated as a publicly traded partnership taxable as a corporation.99
Home equity loans may often have longer lives than credit card receivables, which could exacerbate the gain acceleration issue in considering use of the FASIT. However, efficient utilization of the master trust structure for revolving home equity loan securitizations has been hampered by the taxable mortgage pool rules, which effectively prevent multiple classes of securities (except multiple class structures that implement purely credit subordination). It may be that the enhanced flexibility of any kind of multiple classes available through FASITs will in many cases outweigh the particular gain acceleration and other unfavorable FASIT effects for revolving home equity transactions.
In addition to gain acceleration and the tainted treatment of ownership and high yield regular interests for post-September securitization transactions, a looming concern for any sponsor of a pre-existing master trust is the transition issue in connection with cross-pooling of pre- and post-September 1 securitizations (as discussed earlier in this memorandum).
Grantor Trusts. A FASIT provides for significantly increased flexibility by comparison to the typical grantor trust transaction. For example, a grantor trust must be a fixed, self-liquidating pool that provides for no reinvestment -- or even additional investments -- in newly acquired assets. In addition, other than in connection with pure credit subordination and certain bond stripping transactions, grantor trusts are generally prohibited from issuing multiple classes of interests (e.g., fast-pay/slow-pay classes). A FASIT has no constraints on reinvesting the proceeds of maturing permitted assets in new permitted assets and can issue additional regular interests continuously for the purpose of securitizing additional permitted assets.
However, because medium-term and long-term assets such as auto loans are typically the subject of a grantor trust securitization, the accelerated gain provisions applicable to a FASIT may cause a significantly higher up-front tax cost than the up-front tax cost of a grantor trust.
REMICs. A FASIT may have significant advantages over use of a REMIC for certain mortgage-backed vehicles. For example, a REMIC must be a fixed pool of mortgages, whereas a FASIT will be able to acquire additional mortgages and issue additional regular interests after its start-up day. Thus, a FASIT will generally be able to provide greater certainty of expected timing of payments on FASIT securities than a REMIC in numerous transaction settings.
However, since real estate mortgages are typically longer-lived, the accelerated gain recognition under FASIT will often be a significant concern in mortgage securitizations. Nonetheless, many mortgage-backed instruments that are securitized are traded on an established securities market. It can be expected that FASIT gain recognition in such a transaction would typically not be any more onerous than the equivalent gain effect of a REMIC transaction.
In many cases, the comparative advantages of REMIC will outweigh any added flexibility the FASIT could offer. For example, an "interest-only" REMIC security is not treated differently than any other REMIC regular interest that constitutes a debt instrument in the hands of an investor. By contrast, the unfavorable treatment of an "interest-only" FASIT security as a tainted high-yield regular debt interest effectively limits the category of possible investors.
The FASIT vehicle is a welcome addition to the array of structures that are available to facilitate tax efficient securitization of credit cards, home equity loans, trade receivables, mortgages, and other debt instruments. In some respects, it is a simplified, improved, and expanded version of the REMIC (although it markedly departs from the REMIC "separate entity" conceptual model). The FASIT also draws upon many of the well-developed (and relatively well-understood) REMIC terms and provisions (for example, rules pertaining to asset composition and the permitted characteristics of interests issued by the vehicle), which should to some degree facilitate understanding of FASIT in the securitization industry. However, it is possible that some of the negative aspects of the FASIT legislation (i.e., the special up-front gain calculation, the severe taint of residual or equity-like income, and the extent to which certain issues were left open for resolution by regulations) will materially impede its widespread utilization.
If there are any questions regarding the issues discussed in this memorandum (or other FASIT issues), do not hesitate to call George W. Craven (312-701-7231), Thomas R. Hood (212-506-2595), William Levy (312-701-8049), or David Goldman (212-506-2534) for additional information.
Article by: William Levy,
Mayer, Brown & Platt, May 16, 1997
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1 The legislative history to the FASIT rules provides that, as under the REMIC rules, a FASIT election may also be made by a sponsor for a segregated pool of assets, even though the pool does not constitute a separate legal entity. Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 104th Congress 260 (December 18, 1996) (hereinafter, "1996 Blue Book"). Return to article
2 Internal Revenue Code of 1986, as amended (the "Code"), Section 860L(a)(1). All section references hereinafter are to the Code. Return to article
3 Section 860H(a). Return to article
4 Section 860H(b)(1). This memorandum emphasizes the leveraged asset pool model to facilitate an understanding of the operation of many FASIT technical provisions. However, the model is not perfectly carried through in the legislative provisions, and not all technical issues can be conclusively resolved at this time by reference to it. For example, a FASIT ownership interest is treated for certain purposes as if it were a separate security (e.g., for purposes of applying wash sale principles).
Although the leveraged ownership model will presumably be helpful in applying state tax laws, the treatment of a FASIT for state tax purposes is currently uncertain, and may vary from state to state. The previous experience with REMICs suggests that many states will follow the federal treatment. This will likely require legislation in a number of states, although in others it is likely to be achievable by administrative interpretation. Return to article
5 Section 860H(c)(1). Return to article
6 A certificate issued by a master trust traditionally must be rated at least "A" in order for tax counsel to issue an opinion that the certificate will be treated as debt for federal income tax purposes. Return to article
7 Section 860I(a). Return to article
8 See notes 21-26 below and accompanying text. Return to article
9 See notes 13, and 52-53 below and accompanying text. Return to article
10 See notes 58 and 59 below and accompanying text. Return to article
11 Section 860L(a)(1)(A). Return to article
12 Section 860L(a)(1)(B). Return to article
13 Sections 860L(a)(1)(C)and 860L(a)(2). Return to article
14 1996 Blue Book at 259. Return to article
15 Section 860L(a)(1)(D). Return to article
16 See Treasury regulations section 1.860D-1(b)(3)(ii). Return to article
17 Section 860L(a)(1)(E). Return to article
18 Section 860L(a)(3). Return to article
19 Section 860I(a)(1). There are additional rules requiring recognition of any gain under the FASIT calculation (i) where the asset is purchased by the FASIT from an unrelated party or (ii) where the asset is transferred to the FASIT by a party related to the holder of the ownership interest. Sections 860I(a)(1) and 860I(a)(2). Return to article
20 Section 860I(d)(2)(A). Return to article
21 Section 860I(d)(1)(B). Return to article
22 Section 860I(d)(1)(A). Return to article
23 1996 Blue Book at 266. Return to article
24 For example, 120 percent of the short-term applicable federal rate (up to three year maturities) for May 1997 (assuming annual compounding) is 7.51 percent. It is not uncommon for credit card receivables, sub-prime auto loan receivables and other typical consumer assets to have annual gross yields exceeding 20 percent (not taking into account the permitted losses, prepayments, and costs, which nevertheless in many cases would not radically reduce the net yield to an amount near the range of the federal reference rate). Return to article
25 Whether the publicly-traded or non-publicly traded valuation rule is applied, gain upon transfer to the FASIT will increase the basis of a transferred debt instrument, thus increasing amortization of premium, or decreasing amortization of market discount, and thereby decreasing the taxable yield that would otherwise have been reported by the FASIT.
The special non-publicly-traded valuation rule applies only to debt instruments; all other transferred assets, in addition to publicly-traded debt, are valued conventionally. Return to article
26 Section 860I(b). Return to article
27 As indicated in the text above, the permitted asset test must be satisfied at all times after the close of the third month beginning after formation of the FASIT, and the "substantially all" standard will presumably be interpreted with reference to the pre-existing REMIC one percent safe harbor. See notes 15 and above and accompanying text. Return to article
28 Section 860L(c)(1)(A). Return to article
29 Section 860L(c)(1)(B). Return to article
30 Section 860L(c)(2). Return to article
31 Section 860L(c)(1)(D)(i). Return to article
32 Section 860L(c)(1)(D)(ii). Return to article
33 Section 860L(c)(1)(E). Return to article
34 Section 860L(c)(1)(C) and 860L(c)(3). Return to article
35 Section 860L(c)(1)(F) and 860L(c)(1)(G). Return to article
36 Section 860L(a)(1)(B). Return to article
37 Technically, the statute provides that the ownership interest and regular interests must be issued after the FASIT's start-up day. See Sections 860L(b)(1)(A), 860L(b)(2) and 860L(d)(1). Presumably this provision should be interpreted to allow issuance on or after the start-up day. (The REMIC provisions call for issuance of REMIC interests "on the start-up day". Sections 860G(a)(1) and 860G(a)(2).) Return to article
38 Section 860H(b)(1). In calculating its net income in respect of the FASIT for this purpose, the holder of the ownership interest must report income with respect to each debt instrument held by the FASIT according to a constant yield method (including the rules requiring use of a prepayment assumption for calculating original issue discount on pay-through bonds) in determining all income, acquisition and original issue discount, market discount and premium. Section 860H(b)(2). Return to article
39 Section 860H(c)(1). The applicable high-yield debt obligation ("AHYDO") rules which would otherwise apply to defer a portion of any deduction for original issue discount on certain debt instruments having original issue discount and a yield of greater than 5 percentage points over the applicable federal rate do not apply to FASIT regular interests. Section 860H(c)(2). Return to article
40 Section 860L(b). Return to article
41 Section 860L(b)(1)(A)(i). Return to article
42 Section 860L(b)(1)(A)(ii). Thus permissible rates generally include, for example (i) rates based on LIBOR or a cost-of-funds index, and (ii) subject to certain limitations, rates based on the weighted average of interest rates on the underlying debt instruments held by the FASIT. In addition, an otherwise permissible rate can be subject to certain caps, floors, or multipliers. Return to article
43 Section 860L(b)(1)(A)(iii). Particularly in real estate mortgage securitizations, the instruments being securitized can sometimes have maturities longer than 30 years. Since regulations are required before FASIT regular interests with a duration longer than 30 years can be issued, early Treasury attention to an extension of the permitted maturity is merited. Return to article
44 Section 860L(b)(1)(A)(iv). Return to article
45 Section 860L(b)(1)(A)(v). Return to article
46 Section 860L(b)(1)(B)(ii)(I). Return to article
47 Section 860L(b)(1)(B)(ii)(II). As in the REMIC provisions, the specified portion of interest may not vary during the period the interest is outstanding. Return to article
48 Sections 860J and 860K. Return to article
49 Section 860H(c)(1). Return to article
50 Section 860H(c)(3). Return to article
51 See Section 1272(a)(6). Return to article
52 Section 860K. Return to article
53 Section 860K(a). Return to article
54 Section 860K(b). Return to article
55 Section 860K(e). Return to article
56 Section 860K(e)(1). Return to article
57 Section 860K(e)(2). Return to article
58 Section 860J. Return to article
59 Section 860J(d). Return to article
60 Section 860L(e). Return to article
61 Section 860L(e)(1). Return to article
62 Section 860L(e)(2)(A). Return to article
63 Section 860L(e)(2)(D). Return to article
64 Section 860L(e)(2)(C). Return to article
65 Section 860L(e)(2)(B). Return to article
66 Substitutions are only allowed if "a principal purpose" of the FASIT's acquisition of the original debt instrument was not to recognize gain (or reduce loss) as a result of increase in its market value after its acquisition by the FASIT. Section 860L(e)(3)(B). Return to article
67 See Sections 860F(a)(2)(A)(i) and 860G(a)(4) and Treasury regulation Section 1.860G-2(f). Return to article
68 Section 860L(e)(3)(B). Return to article
69 Section 860L(d)(3)(B)(ii). As in the case of a substitution, the distribution of an over-collateralized asset is only allowed if "a principal purpose" of the FASIT's acquisition of the asset was not to recognize gain (or reduce loss) as a result of an increase in its market value after acquisition. Section 860L(d)(3)(B). Return to article
70 Section 860L(e)(3)(A). Return to article
71 Section 860L(e)(3)(A)(ii). Return to article
72 Sections 860L(e)(3)(A)(ii) and 860L(e)(3)(C). Return to article
73 Section 860L(f)(1). Return to article
74 Section 860L(f)(2). Return to article
75 Section 860G(3)(D). Return to article
76 Because the FASIT provisions are based on a leveraged ownership model, as indicated earlier in text, such regulations could permit the election to be made on the federal income tax return of the holder of the ownership interest rather than providing for a separate filing. Return to article
77 See Small Business Job Protection Act of 1996, Pub.L. No. 104-188, Section 1621(e) (hereinafter, "SBJPA"). Return to article
78 SBJPA Section 1621(e)(1). Return to article
79 SBJPA Section 1621(e)(3)(B). Return to article
80 SBJPA Section 1621(e)(2). Return to article
81 SBJPA Section 1621(e)(2). Return to article
82 The fair market value of all the supporting properties would be greater than $107 million, and thus would exceed 107 percent of the pre-FASIT interests (i.e., the $100 million of previously outstanding investor certificates). Return to article
83 An issue related to that described in the text is the need for guidance on the meaning of "support" in various contexts in the legislation. For example, the legislation specifically leaves open for regulatory guidance the extent to which gain that is otherwise required to be recognized with respect to assets transferred to a FASIT can be postponed until they support FASIT regular interests. See Section 860I(c). The concept of support reflected in the legislative history is quite broad. However, at least in warehousing arrangements and certain master trust structures in which a fractional interest in the debt pool reflecting the sponsor's interest does not provide credit enhancement to the investor interests, such portion of the pool presumably should not be considered to provide support and should not be subject to gain recognition. Another concern involves assets "outside" the FASIT that can be considered to provide support. Not only might there be a gain impact for such assets, but FASIT qualification is affected if any such asset is not a permitted asset. Presumably, in cases where there might be direct or indirect general liability recourse to the sponsor with respect to FASIT regular interests, this will not cause all other assets owned by the sponsor to be considered to provide FASIT support. Return to article
84 Relief relating to these issues (as well as the gain recognition transition issue described in the preceding heading in text) could be provided by, among other technical methods of relief, allowing the new securitization to qualify for FASIT treatment as a separate FASIT under given conditions, despite the presence of cross-pooling in a single master trust vehicle with the earlier pre-FASIT securitizations. Return to article
85 Section 860L(c)(1)(D). Return to article
86 Section 860L(c)(1)(D)(i). Return to article
87 Section 860L(c)(1)(D)(ii). Return to article
88 Section 860L(c)(1)(E). Return to article
89 Section 860I(d)(1)(A). Return to article
90 Section 860I(d)(1)(A)(ii). Return to article
91 Section 860L(a)(1)(B). Return to article
92 See Treasury regulations section 1.860D-1(b)(2). Return to article
93 See section 860I(b). Return to article
94 1996 Blue Book at 259. Return to article
95 See section 860L(a)(1)(C). Return to article
96 As in the REMIC legislation, the FASIT legislation provides some relief in the event of an "inadvertent termination" of FASIT qualification that is remedied within a reasonable time. Section 860L(a)(5). However, given the requirement of Treasury case-by-case determination whether there has been adequate compliance to grant relief under this provision, this provision provides no practicable solution for the concern raised in the text. Return to article
97 Section 860D(a)(6). Return to article
98 It is noteworthy in this regard that the leveraged ownership model of the FASIT legislation, among other effects, causes any prohibited transaction tax liability to fall on the holder of the ownership interest. It is possible to generally interpret the FASIT legislation, at least where an initially qualified FASIT is subsequently disqualified, such that the principal adverse tax effects of disqualification also fall almost exclusively on the holder of the ownership interest. Such interpretation, which may require Treasury guidance, could at least mitigate the concern expressed in the text. Return to article
99 Transfer constraints that do not affect the favorable tax treatment of the FASIT at the entity level will, of course, be necessary in connection with issuance of high-yield regular interests. See section 860K. Return to article
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