Securitisation 2007: A permanent solution
A new tax regime for UK companies involved in securitisations was introduced by Parliament last December. The permanent regime, which replaces the temporary regime created by Finance Act 2005, facilitates the setting up of UK-based SPVs, and is likely to be used for UK securitisations. William Thornhill reports.
Since the mid 1990s the taxable profit of UK companies and SPVs has been calculated on accounting profit. In the case of SPVs, up to the end of 2004 this corresponded to the surplus of cash held by SPVs.
The corporation tax regime governing debt and derivatives is accounts-based, and according to accounting firm Deloitte, following the introduction of international accounting standards (IFRS) or modified UK GAAP there were concerns about potentially large-scale adverse accounting volatility, particularly with relevance to financial instruments that might expose securitisation companies to a risk of commercial failure.
The introduction of fair-value requirements as prescribed under IFRS meant that accounting profit could differ markedly from cash surplus for UK SPVs. If an SPV's taxable profit were to continue to be based on the accounting profit, tax liabilities could arise that might exceed the cash surplus for the relevant period. These unfunded tax liabilities could have pertained to securitisations that were structured as tax neutral, and in certain circumstances the tax liabilities could have given rise to tax charges, despite the lack of any cash to pay the tax.
The UK government addressed these concerns by announcing a short-term solution in the form of the Finance Act 2005. This temporary solution permitted securitisation companies to be treated for corporation tax purposes as if they had produced accounts in accordance with UK GAAP as it existed for periods of account ending on December 31 2004, in other words before there was any requirement to use IFRS or the IFRS-aligned UK accounting standards relating to financial instruments.
In essence, the new permanent regime enacted in December 2006, gives life to the temporary regime by effectively extending the temporary regulations. In broad terms, the law allows companies to pay a largely pre-determined amount of corporation tax or in some cases no tax at all. The permanent regime puts UK securitisation companies on a firm footing, and because it delivered certainty regarding the tax treatment of UK SPVs, the regime also satisfied rating agency concerns.
The detailed provisions of the permanent regime are contained in The Taxation of Securitisation Companies Regulations 2006.
The regime seeks to tax a "securitisation company" on its "retained profit" for periods of account beginning on or after January 1 2007. The "retained profit" can be an amount or margin chosen by the directors of that company, provided that it is clearly identified in the securitisation documents, such as in the "priority of payments schedule".
Eligible securitisation companies that meet the conditions will be charged corporation tax on their retained profit, that being the amount left after the operation of the payments waterfall (with adjustments for certain dividends received and paid by the SPV).
Where an SPV does not have available funds equal to its retained profit, corporation tax will be calculated on the amount of profit actually retained. This avoids the need to compute an SPV's corporation tax in accordance with its accounting profit. As such, the practical difficulties regarding the fair valuation of derivative contracts are eliminated.
Although there are five types of "securitisation company", the most important is the "note-issuing company". To be eligible, such a company must issue securities worth more than £10m as part of a "capital market arrangement," an arrangement whereby security over financial assets is granted to a trustee that holds the assets on behalf of holders of debt securities.
While the new regime is expected to have particular relevance for CMBS it may also extend to CDO/CLOs, project financings and other synthetic structures.
Trade, lease and hire-purchase receivables should also fall within the scope of the new regime. However, operating companies in whole business securitisations and property owning companies in real estate securitisations may be excluded.
To ensure the securitisation company does not roll-up cash tax-free it must satisfy the "payments condition". This requires it to pay out all cash, other than retained profit, within 18 months of the end of the accounting period in which it is received, unless such cash is reasonably required for future losses or expenses or to maintain creditworthiness.
The regime applies to new securitisations. Although companies involved in existing securitisation transactions will not automatically benefit from the regime, they may make an election to be included, provided they satisfy the conditions of the new regime. If these conditions cannot be satisfied, or if no such election is made, an existing securitisation company's protection against tax liabilities resulting from IFRS-style fair-value accounting movements will be no better than the protection available to any other UK non-securitisation company.
There are no changes to the UK withholding tax rules under the new regime. Accordingly, listing of notes will still be required to enable interest to be paid gross. The new regime does not affect any legislation concerned with stamp taxation or VAT so the impact of these taxes on SPVs will still need to be considered.
Limited recourse notes
In addition to placing the taxation of UK securitisation companies on a permanent footing, the new regime has also removed one of the main obstacles to issuing "limited recourse notes".
Tax regulations have historically caused difficulties for UK securitisation companies wanting to issue limited recourse notes though it should now be possible for a securitisation company to issue notes on limited recourse terms, subject to resolving one further obstacle.
"Limited recourse notes are unlikely to be exempt from UK stamp duty on transfer unless issued in 'bearer form'. However, the issue of 'bearer form' limited recourse notes is problematic under US TEFRA D rules," said Adam Blakemore, partner at legal firm Cadwalader Wickersham & Taft.
While the issuance of bearer notes could be restricted to non-US persons, this is unlikely to be commercially attractive. Potential solutions may include the issuance of bearer form notes in their entirety to a depositary that in turn issues custodial receipts.
According to Blakemore, securitisation companies could also (less probably) include reliance on certain IRS statements. In IRS Notice 2006-99, book entry bearer form notes can be treated as being in registered form where they are immobilised in a clearing service with limited circumstances for materialisation in definitive form.
Despite these teething problems, Blakemore believes the permanent regime will become significant. The regime: "may lead to increased interest in the use of UK issuers for CMBS and other standard securitisation transactions, perhaps partly reversing the trend for establishing new securitisation issuers in jurisdictions with bespoke securitisation regimes such as Ireland and Luxembourg," he said.
The inaugural deal to utilise the permanent regime – Bruntwood Alpha – priced in January via RBS at the tight end of guidance for the Triple As and inside original price talk for the Double As and Single As. Mark Thomas, a partner at Addleshaw Goddard who worked with Allen & Overy on the deal, believes the new permanent regime is likely to work out cheaper for arranging bank conduits.
"The lack of requirement for treaty relief is likely to make this attractive for UK RMBS and CMBS, in particular. It could be argued that, as more banks and law firms become familiar with the new regime and comfortable with the implications of it, we may see increased use of UK CMBS issuers for conduit deals, although parties will need to be comfortable that correct accounting treatment applies to the swaps in such deals. Some banks will continue to use offshore issuers for their conduits, but it would be surprising if, over time, others did not see cost benefits in taking advantage of the new regime," said Thomas.
The caveat here is that those banks that have invested in establishing significant operations in Ireland, and moved there specifically to use that country's tax laws, are unlikely to return to the UK.
While CMBS originators will use the new regulations for its ease of tax planning, the regime is unlikely to impact some types of off-balance sheet issuers that would want to get shares "held on trust for charity".
For a true off-balance sheet treatment the issuer is usually based in Jersey and the shareholders of that company are held on trust for charity, which effectively means it is not owned by anybody connected to the originator. A nominal amount is forwarded to that charity as part of the deal, but the rest of profits are taken out through other means.
Most European CMBS are London based and UK domiciled, although a number use, in conjunction, offshore jurisdictions as CP conduits. But for the vast majority of London-based conduits this new law is indeed relevant.