Proposed FASIT regulations, after a long delay, were recently released by the IRS. Financial asset securitization investment trusts ("FASITs") were authorized in 1996 in recognition of the need for a tax advantaged elective securitization vehicle. FASITs, however, have been used rarely since becoming available in 1997, in part, because of the lack of regulations clarifying ambiguous provisions and mitigating some troublesome ones. Also, the adoption of FASB 125 and the adoption of the check-the-box partnership classification regulations in 1996 permitted many types of securitizations to be done with more efficient structures than previously possible, thereby largely pre-empting the need for, and use of, FASITs for these securitizations.
The proposed regulations, however, have numerous shortcomings and will require substantial reworking if FASITs are to become a viable securitization vehicle. Among other things, the proposed regulations do not go far enough in reducing the artificial gain on assets transferred to a FASIT which is subject to up-front tax and adopt several rules that are at odds with the FASIT statute and legislative history, resulting in uncertainty and added cost.
As a result of the developments in the securitization market since 1996 and the unfavorable rules adopted in the regulations it is unlikely that issuers will replace the existing tried and true securitization structures with FASITs. For example, the existing structures for credit card and auto loan securitizations are reasonably efficient and likely will not be replaced with FASITs at least until something is done to reduce the up-front gain recognition on transferred assets. Similarly, collateralized loan obligation (CLOs) or collateratized debt obligation (CDOs) offerings will likely also continue to be accomplished using the current structures.
On the other hand, FASITs will be very useful to securitize mortgage assets (such as home equity loans and franchisee loans) where the use of a REMIC is difficult or impossible. Assuming that the regulations are cleaned-up, FASITs might generally be used instead of REMICs for all mortgage assets because of the greater flexibility of the FASIT regime (provided that not too much artificial gain would be recognized on the transfer of assets to the FASIT). Otherwise, at least for the time being, the use of FASITs will largely be limited to special situations.
Principal Developments in the Regulations
Gain recognition on assets transferred to FASIT. Gain on assets transferred to a FASIT is taxed to the "owner" of the FASIT (typically, but not necessarily, the originator) at the time of transfer. For this purpose non-publicly traded assets (such as credit card, auto and trade receivables) are valued by discounting the payments reasonably expected to be made thereunder at 120% of the yield on Treasury securities with similar maturities. This method usually overstates the value, thereby creating artificial gain on which tax must be paid up-front.
It had been hoped that the proposed regulations would permit gain on readily valued non-publicly traded assets to be based on their actual market values thereby eliminating this tax on artificial gain. While the proposed regulations provide relief for assets newly purchased by the FASIT owner (no gain on assets transferred to a FASIT within 15 days of purchase for cash from an unrelated third-party), nothing was done to mitigate the artificial gain in the case of receivables and loans originated by the FASIT owner.
FASIT "roach motel." The FASIT statute, like the REMIC statute, imposes a 100% tax on certain "prohibited transactions." Under the proposed regulations, absent IRS consent, voluntary termination of a FASIT (pursuant to a clean-up call or otherwise) results in the imposition of this 100% tax on the mark-to-market gain on any FASIT asset (gain or loss is separately determined for each asset, and gains are not offset by losses). Also, if any regular interest issued by the FASIT is redeemed for less than the "adjusted issue price" of the interest, the difference is taxed as cancellation of debt income; but, no deduction is allowed if a redemption premium is instead paid. While these harsh rules (which are inconsistent with the FASIT statute) may be avoided if the IRS consents to the termination, obtaining timely consent will not be feasible in many, if not most, cases. Moreover, the proposed regulations do not specify what "price" will have to be paid for consent.
"Safe-harbor" for non-qualifying assets. The FASIT statute, like the REMIC statute, requires that substantially all of the assets held by the entity be qualifying assets. The REMIC regulations provide a 1% safe harbor, which permits the substantially all requirement to be satisfied (based on facts and circumstances) even if the 1% safe harbor is not met. Non-qualifying assets of a FASIT, however, are limited under the proposed regulations to 1% of the FASIT's assets without exception. There is no apparent policy reason for this difference under the FASIT regulations, which increases the possibility of an inadvertent disqualification of the FASIT.
Delinquent assets. A debt instrument will not be a qualifying asset if a payment default exists on the day it is transferred to the FASIT, unless the FASIT owner reasonably expects the default to be cured within 90 days. This proposed rule will be especially troublesome for securitizations of consumer receivables, where not uncommonly a significant portion of the pool may be currently performing, although in technical default, because of late payments.
No foreign FASITs. Because of concern that cross border FASITs might be abused, a foreign entity cannot elect to be a FASIT. Also, any FASIT will be disqualified if its assets are subject to foreign tax on a "net basis." These restrictions should not pose a problem for the typical domestic securitization.
Guarantees of FASIT assets. A FASIT would be disqualified if the FASIT owner provides a guarantee which has a value of 3% or more of the value of the FASIT assets. Determining the value a guarantee with any precision may not be possible in many cases, thereby creating uncertainty whether the securitization qualifies as a FASIT. The rationale for this rule is a complete mystery.
Anti-abuse rule. A far-reaching and problematic anti-abuse rule is adopted by the proposed regulations. While the rule is generally patterned on the one used in the partnership area, it goes well beyond the partnership rule. Under the FASIT anti-abuse rule any tax result is subject to recharacterization if such result was not "clearly contemplated" by Congress even though the result is clearly permitted by the simple application of the FASIT provisions. Except in cases of plain vanilla securitizations, the "clearly contemplated" standard may be nearly impossible to meet, at least in the absence of examples in the regulations and other guidance regarding the application of the rule.
Loan origination. The FASIT statute imposes a 100% prohibited transaction tax on the income from any loan originated by a FASIT. The proposed regulations provide five safe harbors relating to loan origination. Under the most useful safe harbor, a FASIT will not be considered to originate a loan if the loan is acquired from a person (including the FASIT owner) that regularly originates similar loans in the ordinary course of its business. Also, a loan will not be treated as originated by a FASIT if the loan is made under a line of credit (provided the FASIT did not originate the line of credit).
Gain recognition regulatory glitches. The regulations provide that gain recognized upon the transfer of assets to a FASIT may not be offset by non-FASIT losses. While the FASIT statute limits the ability of the owner to use non-FASIT losses to offset income from FASITs, there is no similar statutory limit with respect to the use of non-FASIT NOLs to offset the transfer gain.
The regulations, contrary to the statute, also attribute the gain on the transfer of assets to the FASIT by affiliates to the FASIT owner. The IRS was concerned that, absent such attribution, realized gain might completely escape U.S. tax (for example, where the selling affiliate is a foreign company). The statute, however, was purposely drafted not to so attribute the transfer gain.