Current developments affecting the securitisation and derivatives markets (2023)

Tuesday 28 February 2023

Joe Sullivan

Covington & Burling, Washington, DC


Report on the session of the Taxation Section at the 12th Annual London Finance and Capital Markets Conference in London

Monday 16 January 2023

Session Chair

Bernadette Accili Orrick, Milan


Adam Blakemore Cadwalader Wickersham & Taft, London

Reinout de Boer Stibbe, Amsterdam

Mark H Leeds Mayer Brown, New York

James Somerville A&L Goodbody, Dublin


United Kingdom: securitisation and non-performing loans (NPLs)

Adam Blakemore began by discussing updates regarding UK rules that apply to securitisation companies. To be within the rules, Blakemore noted that a company must be acquiring and managing financial assets. Blakemore stated that only financial assets are in the regime and will cause a company to be considered a securitisation company, and having non-financial assets will cause a company to fall outside the regime. There are specific rules in the regulations to determine which assets are properly considered ‘financial assets’, and there are tensions relating to some of the definitions, which have been particularly challenging during the difficult period of the last several years. One example is NPLs. Blakemore emphasised that while these are in fact ‘loans’, they are non-performing and entitled to specific benefits in the UK, including the ability to be managed by an originator. Blakemore stated that there is very little actual ‘management’ needed with these loans. This has become an issue for many clients in recent years. Because of events like Covid-19 and Ukraine, there has been some ‘management’ required for these loans, but not the sort of management that we would normally care about for the securitisation company regime. Thus, it is not clear where NPLs fit in this regime.

Blakemore explained that the standard for a securitisation company is that it must be ‘acquiring, holding and managing financial assets’. But what about incidental activities, which are out of scope for a securitisation company’s activities? As an example, Blakemore mentioned that he has seen management clients trying to manage loan origination businesses, where they are trying to comply with both UK and United States origination rules. One common issue is where a vehicle in the UK issues notes from collateralised loan obligation (CLO) special purpose vehicles (SPVs) and submits them to originators, and the notes are on-sold to noteholders. The concern is that this could, in theory, be considered ‘acquiring, holding and managing’ financial assets, and the government thinks that these types of assets might be included in the securitisation regime, even though the originator isn’t actually managing the assets in a material way. However, the government has agreed that these types of activities are ‘incidental’, and thus unlikely to be covered by the regime.

Blakemore briefly discussed derivatives and beneficial ownership. Various items of guidance, including UK law, European Union directives, the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention and His Majesty's Revenue and Customs (HMRC) guidance, provide a definition of beneficial ownership that could pose problems for derivatives. In general, derivatives that ‘back out’ beneficial ownership shouldn’t cause a problem because derivatives typically do not create withholding tax obligations because beneficial ownership is not typically traced through derivatives. However, Blakemore noted that tracing does happen from time to time and is not entirely a ‘slam dunk’ that allows withholding tax to be avoided.

Ireland: current developments affecting the securitisation and derivatives markets

James Somerville discussed an update on Irish rules. He started by discussing Irish ‘Section 110’ companies and noted that the purpose of this special Irish regime is to ensure tax neutrality in Ireland on these sorts of companies. Somerville noted that more than $1tn in assets are held through Irish securitisation vehicles. The way this works is that Section 110 companies are ‘normal’ Irish companies, but taxed under a special regime set out in Section 110 of the Tax Act. Typically, these are not ‘trading’ companies, but are able to calculate taxes as though they were trading companies. Additionally, rules that would deny tax deductibility for profit dependent and excessive interest are turned off. The regime also provides a VAT exemption and broader interest withholding tax exemptions, and Somerville emphasised that this is a generous regime. Certain reductions have been imposed under the Anti-Tax Avoidance Directive (ATAD) I and II rules, which have changed Section 110 companies, to a certain extent. Anti-hybrid rules were applied in 2020 and interest limitation rules were applied in 2022. Somerville stated that the interest limitation rules caused much concern about how they would affect Section 110 company structures. However, both legislation and guidance have achieved what Somerville called ‘good results’ on this because either there really is no excessive interest being paid or the entities are part of a single company worldwide group and therefore out of scope for the rules. Legislation also clarified the treatment of discounts, derivative hedging agreements, guarantee fees and other items. One additional item of clarification related to the portion of profits that are considered ‘economically equivalent’ to interest. Somerville said that this rule could be very problematic, and different from the position in the UK because it is common for Irish companies to acquire assets like NPLs and then work them out, eventually selling them for capital gain/return of principal. There is a portion that is treated as interest and the rest is treated as return of principal; thus, the interest equivalency rules can be very important.

In the context of NPLs, Somerville noted that there is a possibility that a Section 110 company might receive other assets as part of a conversion in which shares are received. In Ireland, there is no difficulty with Section 110 companies in this respect. Somerville stated that guidance has generally achieved good results in this area, as well as with respect to other regimes, including repo transactions and Islamic finance regimes.

Somerville discussed the concept, mentioned earlier, of a ‘single company worldwide group’. This concept applies because of the way in which Section 110 companies are generally owned: through having shares held by a trustee on trust for a charitable purpose and not technically as a ‘standalone entity’ within the EU Directive, but also not within a ‘group’ in the normal sense, and thus not able generally to claim group treatment. Finally, Somerville stated that Irish law allows for the treatment of these entities as part of a group on a notional basis, so there is no material impact under Irish law.

Italy: proposed transaction on performing real estate leasing

Bernadette Accili walked through a transaction on performing real estate leasing in Italy. Accili noted that the tax treatment of Italian securitisation vehicles is similar to that provided in other jurisdictions. As a general rule, the income of the securitisation vehicle is not subject to any taxation, with only the exception of profits, if any, available after the full discharge of its obligations in relation to the notes and any other creditor of the vehicle itself. Securitisation transactions generally involve receivables from NPLs; hence, real estate securitisations are unusual and controversial. Accili described a securitisation transaction related to performing real estate lease agreements. She had to work with her finance department to structure this in a way that was compliant with both regulatory and tax regulations. Accili noted that the final outcome is extremely complex as the transaction involved performing lease agreements and the underlying ‘heavy’ real estate assets, such as warehouses. Transfers of this type of real estate cannot typically be easily accomplished due to regulatory requirements: some of these properties are immediately transferable, while others are not, with different impacts on the relevant applicable VAT regime. The first step was to transfer all the receivables arising from the lease agreements to an Italian securitisation vehicle (the SPV). In general terms, the transfer of receivables in the context of a securitisation transaction is VAT exempt provided that certain conditions are met. Then, a demerger into a NewCo was carried out. The demerger involved, inter alia, the real estate assets not immediately transferable and the relevant real estate lease agreements. A demerger is generally considered outside the scope of VAT. Immediately following the completion of the demerger, NewCo also acquired the real estate assets immediately transferable and the related real estate lease agreements. Next, the SPV granted to NewCo a loan pursuant to securitisation law; the repayment of this loan will be a limited recourse on the proceeds derived from the assets/receivables included in the segregated portfolio of assets created by the same NewCo. The limited recourse loan allowed payment to various parties to the transaction, followed by the issuance by the SPV of different classes of notes.

The Netherlands: securitisation and derivatives tax update

Reinout de Boer provided an update on Dutch law in this area, starting with the recognition of NPL losses. De Boer’s first slide depicted a very basic situation. The securitisation was a pure pass-through, so all assets held by the SPV were held for investment. Thus, de Boer noted that, in this situation, there is a clear treatment of the NPLs because tax flows through based on performance. However, de Boer stated that this is not standard in the Dutch market. Instead, a more common form is that the SPV just holds the assets for packaging and selling on. This form of the transaction raises many more questions under Dutch law. What de Boer typically sees is deferred purchase prices, which reduce the up-front capital needed. This allows the SPV to have an advantage at the original level and avoid some risk exposure.

De Boer added that another situation is where the SPV is not a true securitisation vehicle. Instead, the real vehicle is a US limited partnership (LP). In this structure, using a case study presented in a slide, the US LP would license intellectual property (IP) rights to an SPV in exchange for royalties, and then the SPV would securitise the rights of the SPV in exchange for royalties, and the SPV would securitise the rights and sell on to eventual investors. According to de Boer, the question is what happens when the SPV receives royalties? Are there withholding issues if the SPV is in a low-tax jurisdiction? De Boer stated that there may be an exception available if the participant owns more than 50 per cent of the interests in the SPV and the payor/payee is also the beneficial owner, which requires some substance. There are also questions regarding substance at the level of Dutch entities and proper remuneration of the SPV for transfer pricing purposes.

De Boer provided an update on dividend stripping in the Netherlands. Rules have not yet been issued on this topic. One of the elements of this issue is that, in the future, the government would only allow for refunds or exemptions of dividend withholding where the recipient of the interest is the entire owner of the economic interest, so this is unlikely to apply in most securitisation fact patterns.

Finally, de Boer walked through recent developments on interest rate swaps under new case law from the Dutch Supreme Court on the redemption of interest rate swaps. De Boer considered four examples presented in the case. In option one, regarding a fixed-rate loan at a time of falling market interest rates, deductions are only allowed at the agreed annual interest rate, not for actual losses in the value of the loan. In option two, involving a premium interest adjustment for a fixed-rate loan in which the loan is subject to substantial modification and the value changes a lot, no immediate deduction is allowed, and the holder is required to capitalise and amortise the instrument over time. In a more complicated example, a variable rate loan is combined with an interest rate swap, resulting in a new substitute loan. In this fact pattern, de Boer stated that because the loans are effectively exchanged, you may be able to take the deduction all at once. In the final fact pattern involving a variable rate loan combined with an interest rate swap, where the loan is terminated and the interest rate swap is surrendered, de Boer stated that it is clearer that the surrendered swap is deductible as a lump sum in the current year.

Securitisation and derivatives: US tax update

Mark Leeds presented a crypto update. He started by noting that crypto is up 30 per cent this year, so if you had the foresight to purchase at year end, you would have a pretty substantial gain. However, US law requires gain recognition if you use crypto to buy goods or services: you have to recognise the built-in gain in the cryptoasset. Leeds noted that regulations placed responsibility on investors in this area, and brokers are not covered by guidance for some scenarios because, currently, the US only has proposed regulations. However, new final regulations will be issued that will make this much clearer. Leeds stated that there is a lot of controversy about the definition of a broker for US purposes, so guidance is likely to make this much clearer.

Leeds has seen many ‘innovative’ pharma funding transactions that are gaining traction. For example, US pharma funds provide funding to pharma startups in exchange for a percentage of revenue from the sale of specific pharmaceutical products. Leeds noted that these transactions are unlikely to be characterised as either debt or equity in the pharmaceutical company, and are instead likely to be treated as a joint venture/partnership. This raises the possibility that the foreign partners in the fund will earn income that is subject to US income taxes because they will be treated as engaged in a US trade or business. However, Leeds added that derivatives can be used to avoid US tax by taking advances of the source or income, or using US trade or business principles.

Leeds next discussed the IRS’s addition of hedge fund lending to the list of high-priority items for audits. The question is whether credit funds and offshore insurance companies are too involved in loan origination such that they are not getting portfolio interest, which is exempt from US tax, and are instead engaged in a US trade or the business of lending. In mid-2021, the IRS decided to make this issue a high-priority item, and now, the IRS has a lot more money to go after non-US investors and investment funds and is likely to start auditing, according to Leeds.

Leeds is also seeing many derivatives in litigation finance. Leeds noted that Burford is the largest and most well-known litigation finance firm. This has been a very attractive asset class for the last year, funding plaintiffs and their lawyers, where the underlying claims are patents or tort claims. The question, according to Leeds, is whether the proceeds are subject to US tax, and then whether the income is either income effectively connected with a US trade or business (ECI) or is instead fixed, determinable, annual and periodical (FDAP) income. Leeds says that he has used instruments that he thinks are likely to be treated as swaps, and thus not subject to US tax for foreigners, and US investors achieve a rate benefit because they get a capital gain on the sale.

Leeds discussed 2023 withholding tax rules that threaten publicly traded partnerships trading outside the US. Starting in 2023, partnerships are required to withhold US tax if the partnership is engaged in the conduct of a US trade or business. Publicly traded partnerships can be both US companies trading shares outside the US and non-US companies that are treated as US entities. Certain brokers are not willing to accept the liability for withholding US tax, even if a publicly traded partnership has no history of a US trade or business. Thus, Leeds noted that he has been structuring ways around this.