This article covers senior-subordinated grantor trusts, limited-liability companies, and Rcmic-like legislation for asset-backed securities.
Grantor Trusts
The grantor trust is a mainstay of the asset-backed securities transaction. The grantor trust, formed under local law, holds debt instruments such as auto loans.
As a tax requirement, the asset pool held by the trust must be fixed to distinguish it from an actively managed investment company. The certificate holders are treated as direct owners of undivided interests in the trust's assets. Therefore, there is no entity-level tax on the trust's income.
Senior-subordinated grantor trusts provide a fascinating story of unwritten rules and how the Intemal Revenue Service, normally regarded as a slothful bureaucratic agency, can act with blinding speed when it's the U.S. govemment asking for guidance.
|Sears Regulations'
Since 1986, the Intemal Revenue Service has prohibited grantor trusts with more than one class of ownership. This prohibition is contained in the "Sears Regulations," named after a famous multiple-class trust deal. The IRS is concemed with tax-abusive allocations of income and deductions between classes of trust certificates.
The Sears Regulations, however, permit a multiple-class senior-subordinated trust. The subordinated certificates bear first losses on the trust assets.
The utility of this vehicle has been limited since 1986, because the IRS has been telling people that if the sponsor put assets in a senior subordinated trust, the sponsor was required to retain the subordinated interest.
The regulations themselves have an example of a senior subordinated arrangement. The example merely states that the sponsor retains the subordinated interest. It does not say that the sponsor must retain the subordinated interest.
Instead, the IRS sent its attorneys around the country in late 1985 and 1986 and had them tell taxpayers that transfers of the subordinated interest would jeopardize classification of the trust as a trust.
The reason for the, unwritten rule? Officially, the IRS will tell you that it viewed the transaction as though there was only one class of investor: the senior certificate holder. Since this was not a multiple-class trust, there was no violation of the regulations.
Unofficially, I've told people for several years that the IRS wanted to keep investment bankers out of the senior/subordinated market.
The easiest way to do this was to "scare" the marketplace with an unwritten rule requiring the sponsor to retain the subordinated interest. Investment banking firms don't like to tie up their capital any longer than absolutely necessary.
High-stakes Game
In hindsight, you might ask why market participants didn't just ipore the IRS. The stakes here are pretty high: a corporatelevel tax on the trust's income if you're wrong.
Therefore, even a hint that the IRS might challenge the transaction was enough to dissuade people from transferring subordinated interests. Unfortunately, it shows the power of the IRS to affect the marketplace outside of the normal administrative and rulemaking channels.
Why the Change?
Why did the IRS change its position after all these years? It doesn't take a rocket scientist to figure-it out. This is 1992. Who owns most of the subordinated trust interests in the Western world? Savings and loan associations. Who owns most of the savings and loan associations? The U.S. govemment. Now things start to happen.
The IRS last year began issuing private letter rulings permitting the transfer of subordinated interests to a single new buyer when a thrift was being liquidated. The transfers were somewhat restricted. That is, the IRS would only allow a one-time transfer. After that, all bets were off.
On Valentine's Day 1992, a branch chief at the IRS was attending an American Bar Association tax section meeting. Someone thought to ask whether the IRS had changed its position. The answer, surprisingly, was "Yes." The tax bar was shocked.
Almost exactly two months after the Valentine's Day surprise, the IRS issued Revenue Ruling 92-32 that precisely reverses the IRS'S unwritten rule. Not bad. I've worked over the years with private clients to try and get published rulings. It's very hard to do. But when the U.S. govemment is involved, things happen - and fast.
What the Rule Means
What does this ruling mean? Take a look at the Chrysler Premier Auto Trust deals recently done with automobile retail installment sales contracts.
Chrysler puts the receivables in a trust. The trust issues a senior debt class and a subordinated equity class of trust certificates. Chrysier sells all the debt class and 99% of the equity class.
For federal income tax purposes the trust is treated as a partnership. To get there, tax counsel must restrict transfer of the subordinate trust certificates. It may also require that the subordinate certificate holders be liable for debts of and claims against the trust (apart from the debt).
Finally, it has to either give certificate holders management power over the trust or have Chrysler retain a 1% interest and require Chrysler's bankruptcy to terminate the trust. The trust has at two of these features to allow tax counsel to opine that the trust is a partnership rather than a corporation for federal income tax purposes.
We can now do the same deal with a grantor trust - but even better.
A Clear Benefit
Chrysler would put the contracts in the trust. The trust would issue senior and subordinated classes of trust certificates.
Chrysler could sell both certificates in a public offering. This is a clear benefit over the existing structure.
For accounting and tax purposes the transaction is treated as a sale. The trust is not classified as a partnership for federal income purposes but as a grantor trust. Therefore, there is no need to restrict transfer of the subordinate interest, no need to make certificate holders hable, no need to have Chrysler re any interest in the trust.
Possible Pitfalls
These transactions present a few other issues. First, under Rev. Rul. 92-32, watch out for reserve ftinds. Most grantor trusts have a reserve fund "outside", the trust where money from the subordinated interest goes until the reserve is full.
Make sure you think about what happens to that reserve fund when the subordinated interest is transferred. In particular, that reserve fund might be taxable as a corporation if you structure it improperly.
Second, it should be possible to tranche the subordinated interest. In the Chrysler deal, multiple classes of subordinated interests could be sold so long as the only difference is the of subordination. This may be an attractive feature.
Third, apart from an initial 90-day formation period, the grantor trust is a purely static vehicle. In the Chrysler deal, for example, there is a six-month period for purchasing all the receivables. Offering proceeds are put in a prefunding account until enough receivables are put in to fill out the deal. That can't be done with a grantor trust.
Limited Liability
A limited liability company is a cross between a partnership and a corporation. Its members have limited liability, like a corporation, no matter how much they participate in the LLC's business. The LLC, however, is treated as a partnership for federal income tax purposes. This is the best of both worlds.
Thirteen states have adopted LLC legislation. The New York state legislature is cuffently considering an LLC statute that would be effective Jan. 1, 1993.
As LLCs become more accepted, I think you'll see more asset securitization being done in the LLC format. Limited liability is the key. We can structure a deal like the Chrysler dcal but protect the subordinated certificate holders from liability. In addition, the LLC is not a partnership, which has a bad marketing taint. That's the reason we use trusts all the time.
The first LLC receivables deal I'm aware of was filed with the Securities and Exchange Commission last fall. Look for more as this vehicle becomes more acceptable.
Pending Legislation
Legislation aimed at perimitting the asset securitization investment conduit, or Asic, started out with a bunch of frustrated tax lawyers drafting amendments to the Tax Reform Act of 1986. They hoped to expand the real estate mortgage investment conduit to include asset-backed securities.
The Asic would be similar to the Remic, with one important exception: An Asic could hold revolving accounts and continue to issue debt. Therefore, You could do credit card and home equity loan deals in an Asic.
Also like the Remic, the asset-securitization conduit would be the exclusive vehicle for securitizing loans. Thus, Asic includes a provision much like the current taxable mortgage pool rules.
Therefore, every creation of an asset-backed receivables vehicle would be a sale for federal income tax purposes. That would include, for example, credit card certificate deals that are cuffently treated as financings for federal income tax purposes.
Exclusivity Disputed
Where is the Asic legislation? As far as I can tell, nowhere. In fact, there is now a competing proposal put together by a group named the Coalition for Asset-Backed Securities that would be a nonexclusive asset-securitization device. I would guess that this group is concerned about the Asic's exclusivity.
Will we ever get legislation? A lot depends on whether Congress perceives the need for tax standardization in the asset-backed area; this was a major selling point for Remic.
A lot also dcpends on convincing Congress that revolving asset deals such as credit card transactions are not finance companies in disguise.
Finally, a lot dcpends on the clout of the people lobbying. My prediction, as always, is a conservative one: The asset-backed market is growing and - sooner or later - Congress will want to regulate it from a tax standpoint. My bet is on legislation before President Ross Perot leaves office.
THOMAS A. HUMPHREYS
Tax Partner Brown & Wood
Thomas A. Humphreys is a tax partner in the New York City office of Brown & Wood.
Mr. Humphreys is currently co-chairman of the New York State Bar Association's tax section committee on passthrough entities and a member of the association's tax section executive Committee.
He was chairman of the American Bar Association's tax section committee on regulated investment companies in 1985-87; cochairman of the tax section committee on financial instruments, 1988-89; and the committee on f inancial institutions, 1990.
Mr. Humphreys has had a wide variety of experience with mortgage-backed and assetbacked securities, mutual funds, real estate investment trusts, financial instruments, M&A, and international transactions. He is a member of the New York and California bars.
Mr. Humphreys is co-author of "Mortgage-Backed Securities, including Remics and Other Investment Vehicies," a volume in the CCH Tax Transactions Library. He is also an adjunct assistant professor of law at New York University, where he teaches a course on taxation of financial instruments in the LLM program.
He received a bachelor of arts degree from the University of California, Los Angeles, in 1974, a law degree from the University of California, Hastings, College of Law in 1977, and an LLM in taxation from New York University in 1979.
