“Toto, I’ve a feeling we’re not in Kansas anymore.” — Dorothy, The Wizard of Oz (1939)
One of the challenges – which on its face appears to present impossible hurdles – of tax attorneys structuring securitization and asset acquisition vehicles over the past decade has been to structure a static pool of distressed mortgages and REO for the purpose of attracting offshore, tax-exempt, and investment fund purchasers.
A number of people called me to ask how this can be done after reading the last article that I posted:
“NPLs, Taxes and Your IRS Partner – 6 Q&As (in Plain English),” which you may find at:
Below are 6 Q&A summaries of some of those conversations:
1. Why isn’t there a one-size-fits-all investment structure? This is a good question. In very general terms, it’s because different investors have different US federal income tax sensitivities with respect to different assets and activities. For example, a US investment fund with only US taxable investors that wants to purchase, workout and hold long-term a static pool of distressed mortgages and REO may purchase the pool directly into the fund generally without creating any material adverse US federal income tax consequences to its investors. However, the same is not true for an investment fund with tax-exempt and non-US investors. If the fund has tax-exempt and non-US investors, the fund is best advised to triple check the representations and covenants that it made to its investors as it relates to UBTI, UDFI, FIRPTA and ECI, and understand the parade of US federal income tax horribles that may arise for those investors from making a similar unstructured investment. Failure to do so will most likely irreparably damage investor relationships.
2. If I were to purchase a pool and market it for sale to investment funds and offshore investors, could you structure and opine on the purchasing vehicle for me? Absolutely – BUT only if you put me on the phone with your potential purchaser (or its tax attorney) first so that I can evaluate its tax sensitivities and determine what structuring, if any, is necessary at the asset acquisition level. Many funds and offshore investors have pre-existing structures in place to deal with purchasing “US trade or business” or “FIRPTA” assets. If there’s no time – or no willingness – to put me on the phone with the potential purchaser (or its tax attorney) before completing the trade, then I generally recommend acquiring the pool into a wholly-owned trust or other state law entity that is not a c-corporation, so that the acquiring entity may be “disregarded” for US federal income tax purposes.
3. How do you devise the most efficient and effective investment structure? In very general terms, I deconstruct the pool by segregating the pool assets (both current and foreseeable) and pool activities (both current and foreseeable) into buckets based in part on their functional independence and tax implications to particular investors. I then construct the simplest structure possible that minimizes tax drag and addresses investors’ tax sensitivities, legal sensitivities, and economic and other business concerns. My tax work, however, doesn’t always stop at structuring. If necessary, I’ll establish operational guidelines to address any material tax issues that may foreseeably arise, for example, from financing or the movement of assets or cashflow throughout the structure. Asset managers with experience in CDOs and CLOs are no strangers to these types of guidelines.
4. Is this how the REMICs, grantor trusts and REO corporations investment structure sprang into existence for investment funds? One of the more complex investment structures that an investment fund with tax-exempt investors and non-US investors may utilize for a pool of distressed mortgages and REO consists of a combination of one or more REMICs, grantor trusts and REO corporations. This structure evolved into existence over the past decade, and did not spring into existence overnight. There are a number of “traps for the unwary” inherent in the structure and its ongoing maintenance, so it’s very important to work with tax attorneys knowledgeable about its intricacies prior to setting the structure into motion.
5. How does the REMICs, grantor trusts and REO corporations investment structure generally work? Below is a summary in very general terms of the deconstruction/construction methodology that I mentioned above in Q&A 3.
I prefer to segregate the pool assets into the following buckets and analyze them in turn: (a) performing loans, (b) reperforming loans, (c) distressed loans at varying levels of distress and (d) REO.
(a) Performing loans. A static pool of performing loans generally is the least problematic of the bucketed assets from an investor’s standpoint. Acquiring the performing loans into a grantor trust places the loans into “registered form.” It creates no US federal income tax drag; and unlike a REMIC, the grantor trust may periodically sell the loans that it owns.
(b) Reperforming loans. A static pool of reperforming loans generally is not problematic from an investor’s standpoint. Acquiring the reperforming loans into a grantor trust places the loans into “registered form.” It creates no US federal income tax drag; and unlike a REMIC, the grantor trust may periodically sell the loans that it owns.
(c) Distressed loans at varying levels of distress. Distressed loans present a number of US federal income tax concerns to tax-exempt and non-US investors. I generally recommend against using a grantor trust to acquire distressed loans. Distressed loans at varying levels of distress may be included in either a REMIC or an REO corporation, depending in part on their REMIC eligibility and imminence to foreclosure. Accordingly, I may bucket these loans into sub-buckets – those that are REMIC-eligible, and those that are suitable only for an REO corporation.
(d) REO. REO presents a number of US federal income tax concerns to non-US investors, and possibly also to tax-exempt investors depending on the particular circumstances. I generally recommend that a non-US investor’s (and possibly a tax-exempt investor’s) direct or indirect interest in REO be owned through one or more REO corporations. More complex structures are also possible.
A newly created “parent” investment vehicle may take ownership of the grantor trusts, REO corporations, and some (or all) of the REMIC regular interests. Within limits, the “parent” investment vehicle may issue various classes of debt and equity.
6. Why does this structure work and what are the “traps for the unwary” that you mentioned above? Pick up the phone and call me – I’m happy to answer any questions that you may have. This isn’t an intuitive area, and there are no stupid questions. You likely won’t find the answers to your questions spelled out in any investment documents or elsewhere online. With your permission, I may include your question in future Q&As.
Todd S. Anderson
Direct Dial: 646-942-0311
61 Massachusetts Avenue, PO Box 205, Hyannis Port, MA 02647