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FASIT primer.

The Small Business Job Protection Act of 1996 (SBJPA) contains legislation introducing the financial asset securitization investment trust (FASIT). The FASIT provisions are elective miles intended to facilitate securitizations of nonmortgage assets in the same way that the real estate mortgage investment conduit (REMIC) legislation has spurred the growth of the market for mortgage-backed securities. Securitization is the process that allows a "sponsor" to repackage a receivable into a more marketable security and thereby obtain greater cash or other benefits from the new security than those available from a direct sale of the underlying receivable.

The FASIT legislation was enacted with the expectation that it would be a revenue-raising provision. The assumption is that the marketplace will be willing to pay the additional tax cost for using FASITs in exchange for structuring flexibility and tax certainty. The benefits of a FASIT election can only be determined by comparative analysis; FASITs may not be a panacea for all types of securitizations. Among the expected beneficiaries of FASITs are credit card trusts, which will receive tax certainty as to entity and debt classification and the enhanced ability to sell subordinated interests.

Even if certain issuers determine that the tax cost of a FASIT negates the benefits of the FASIT election for their current securitization models, the flexibility inherent in FASITs may give rise to modifications to current structures and foster the creation of new structured finance debt instruments. Not only may new, more efficient versions of existing securitization models arise, but completely new instruments may be created.

The FASIT legislation is effective on Sept. 1, 1997. Securitizations in effect before Sept. 1, 1997 (pre-effective date FASITs) may elect into the FASIT rules, subject to special gain recognition provisions (which may be beneficial).

Qualification as a FASIT

An entity may elect to be taxed as a FASIT if five requirements are met.

1. A FASIT election must be made. The election applies for the year in which it is made and for all subsequent years unless revoked with IRS consent. if the election is made after the entity's initial year, all of the entity's assets are deemed contributed at that time; any gain (but not loss) on such assets will be recognized immediately. A FASIT election may be made for an entity regardless of its legal form (corporation, partnership, trust or segregated asset pool).

2. All of the interests in the FASIT must be either an "ownership interest" or "regular interest"

One of the distinct advantages of a FASIT is that a regular interest is treated as debt for all purposes regardless of its characterization in the absence of the FASIT election. A regular interest is an interest in the FASIT that meets all of the following criteria:

* It has a specified principal amount that is unconditionally payable.

* Interest payments, if any, are at a fixed or a qualifying variable rate.

* The interest has a maturity of 30 years or less.

* The issue price does not exceed 125% of stated principal amount.

* The yield to maturity is less than the sum of the yield on Treasury obligations with comparable maturities plus 5%.

A FASIT may also issue a subclass of regular interests referred to as high-yield regular interests. This interest has the same criteria as a regular interest, except it does not meet one or more of the above requirements. (If it fails the coupon requirement, it must meet certain "specified portion" requirements that generally relate to stripped bonds.) The high-yield regular interest rules allow a FASIT to issue interest-only (IO) strips, etc.; however, special restrictions apply to high-yield regular interests. A high-yield regular interest may only be held by a domestic C corporation, another FASIT or (in certain other cases) a dealer in securities. Also, the FASIT rules exact a toll charge for the tax certainty of debt treatment for high-yield regular interests: net operating losses (NOLs) or other "outside" deductions of a permitted holder may not offset the interest income on the high-yield regular interest.

Ownership interests in a FASIT are interests in the FASIT that are not regular interests. The ownership interest in the FASIT is most often treated as evidence of ownership in the underlying assets.

3. There is only one class of ownership interest and 100% of such class is directly held by a single eligible corporation (that is, by my domestic C corporation other than a regulated investment company, a real estate investment trust, a REMIC or certain cooperatives).

4. As of the close of the third month beginning after the day of its formation and at all times thereafter, "substantially all" of the assets consist of "permitted assets." Permitted assets include cash and cash equivalents, most debt instruments (qualified debt instruments), swaps or certain other reasonably required hedging assets, credit enhancement assets (such as insurance and guarantees), REMIC regular (but not residual) interests and regular interests in other FASITs, and certain foreclosure property. Accordingly, FASITs may include a very broad spectrum of assets, including credit card receivables, trade receivables, home equity loans, auto loans, mortgages and related hedging instruments. The requirement that the obligation constitute a debt instrument effectively eliminates operating leases as a permitted asset of a FASIT

If an asset retained by the ownership interest holder or a related person is deemed to support a FASIT regular interest, the FASIT is treated as holding the asset. Therefore, care must be taken to ensure that retained assets do not inadvertently cause the FASIT to fail the asset qualification test.

5. For tax purposes, it does not qualify as a regulated investment company (generally, a mutual fund).

Tax Consequences to Transferor on Transfer of Assets to a FASIT and Special Valuation Rules

The FASIT legislation was enacted with expectation that its provisions would be revenue-raising. The gain recognition provisions are a major source of these expected revenues. In this regard, elaborate rides have been created in anticipation of attempts by sponsors to avoid the gain recognition provisions through indirect transfers or the use of related parties. The tax consequences of asset transfers to a FASIT relate solely to the ownership interest holder (generally, the sponsor).

The rules applicable to the transfer of assets to a FASIT have two significant features. First, only gains and not losses are recognized on the transfer of assets to a FASIT. This is true regardless of whether the ownership interest holder effectively retains the ownership of the assets. Second, the amount of the gain recognized is required to be determined by reference to statutory valuation rules. For nonpublicly traded debt instruments, the valuation used to determine the amount of gain is computed under special valuation rules that may overstate the gain. These rides may produce valuations in excess of those determined in the marketplace and result in the creation of taxable gain when there would be none based on an arm's-length valuation.

Three types of events trigger gain recognition by an ownership interest holder or a person related to the ownership interest holder (a related person, generally as defined in Sec. 267 or 707(b) using a 20% ownership rule).

1. If the ownership interest holder or a related person sells or contributes property to a FASIT, gain but not loss will be recognized by the holder (or related person) in an amount equal to the excess of the property's "value" as determined under the statute on the date of sale or contribution over its tax basis on that date.

2. The ownership interest holder or related person cannot avoid the gain that would be triggered by a transfer of property to the FASIT by holding the property outside of the FASIT. If property is retained by the ownership interest holder (or a related person) and such property supports my regular interest in the FASIT, gain but not loss is recognized to the holder (or related person) in the same manner as if the ownership interest holder (or related person) had in fact transferred the credit support to the FASIT. The statute does not define the term supports, however, the legislative reports indicate that supporting assets include any assets reasonably expected to directly or indirectly pay regular interests or to otherwise secure or collateralize regular interests. Additionally, the property is treated as being held by the FASIT for asset qualification tests, etc. Therefore, it is important to determine whether a retained asset "supports" a FASIT regular interest for purposes of gain recognition by the ownership interest holder, as well as for the FASIT qualified asset test.

3. If a FASIT acquires property from an unrelated third party, the transaction will be recast for tax purposes as an acquisition of the property by the ownership interest holder followed by a transfer of the property by the holder to the FASIT The ownership interest holder is deemed to have acquired the property at the FASIT's purchase price and then to have sold the property to the FASIT for an amount equal to the value of the property as determined by the statute.

A significant feature of the gain recognition rules is that the statute prescribes how the value of the property is to be determined. In the case of property other than debt instruments, its value is its fair market value (FMV). In the case of debt instruments, the determination of value (and hence the amount of the taxable gain recognized) depends on whether the debt instrument is traded on an established securities market. If the debt instrument is traded on an established securities market, its value is its trading price. If the debt instrument is not traded on an established securities market, its value is deemed to be equal to the sum of the present values of the reasonably expected payments as of the gain recognition date (generally, the transfer date). The present value is to be determined by using a 120% AFR (an average Treasury rate contained in a table published monthly by the IRS). This value must be used to determine gain, even though it is different from the FMV that would be established in an arm's-length transaction.

Based on the anticipated definition of the term "traded on an established securities market," many of the assets that will be the subject of securitization (such as credit card receivables, auto loans, construction loans and commercial mortgages) would not be considered to be traded on an established securities market and would be subject to the special valuation rules. The problem is that the 120% AFR is generally lower than the coupon rate on the asset being securitized. Any time this occurs, the resulting statutory valuation will be higher than the principal amount of such debt instrument, triggering an artificial gain due to the spread between the coupon rate and the present value discount factor rate (the 120% AFR).

The FASIT's (presumably, the ownership interest holder's) aggregate tax basis in the assets will be increased by the gain recognized. Through this mechanism, the FASIT (and hence the ownership interest holder) will reverse over time the effects of the upfront income recognition through market premium deductions or other offsets to income. Accordingly, the gain triggered on transfers of assets to a FASIT is effectively a timing difference; it reverses over time to zero. The cost of this FASIT gain rule is the time value of the resulting tax liability (i.e., paying a current tax liability today and receiving future tax refunds over time). Alternatively, if the ownership interest or the underlying asset is sold prior to maturity, an ownership interest holder may recognize a loss on a disposition of an ownership interest (or, for that matter, on a subsequent qualified disposition of the loss asset). Accordingly, the sponsor apparently may reverse the effects of any artificial gain recognition by selling the ownership interest and recognizing an immediate loss. At the current time, however, the character of any such loss is not entirely clear. Additionally, any loss on the sale of an ownership interest would be subject to the wash sale rules.

The legislative reports provide that reasonably expected cash flows from loans should reflect nonpayment losses, early payments and reasonable costs of servicing the loan. Thus, the gain can be reduced based on these assumptions. This places significance on the cashflow projection assumptions in that they will directly affect the current tax liability.

If an asset was subject to the Sec. 475 mark-to-market rules prior to a transfer to the FASIT, the rules will continue to apply to those assets after the transfer. A special rule provides that the FMV may not be less than the value determined under the statutory valuation rules. Additionally, the Sec. 475 mark-to-market rules will not apply to a FASIT ownership interest (a similar rule prevents REMIC residual interests from avoiding phantom income through the mark-to-market mechanism).

Taxation of FASITs

The FASIT rules provide for no entity-level tax. In fact, for most purposes, a FASIT does not appear to be a separate taxable entity from the ownership interest holder. The general statutory scheme appears to be to ignore the FASIT and treat the activities as directly engaged in by the ownership interest holder. However, there are instances of separate entity treatment, see the tax-exempt interest and wash sale rule discussions below. A FASIT is not directly subject to tax for prohibited transactions; however, a 100% penalty tax is imposed on the ownership interest holder for certain "prohibited transactions."

Prohibited transactions are generally transactions inconsistent with the purpose of the securitization vehicle, including income from nonqualifying assets, income from services, and certain dispositions of qualifying assets.

There is an extensive list of exceptions from the prohibited transaction definition, including exceptions addressing qualified dispositions of permitted assets, the substitution of one qualified debt instrument for another, the distribution of a debt instrument contributed by the ownership interest holder to reduce overcollateralization of the FASIT, and disposition of a permitted investment in connection with the complete liquidation of any class of regular interests. Presumably, since the prohibited transaction penalty tax is imposed on net income, there is no restriction on the deductibility of a net loss from a prohibited transaction. However, since such a loss is not treated as part of the taxable income from the FASIT, it appears that the loss would be considered an outside deduction. As such, the loss would be subject to the "no outside deduction" rule discussed below and would not be available to offset FASIT taxable income.

Taxation of the FASIT Ownership

Interest Holder

All assets, liabilities, and items of income, gain, deduction, loss and credit of the FASIT are treated as assets, liabilities, etc., of the ownership interest holder. The ownership interest holder must compute the income from the qualified debt assets under a constant yield method, including the rules of Sec. 1272(a)(6). Any income, gain or deduction allocable to a prohibited transaction is not take into account in the computation of "FASIT taxable income." Tax-exempt interest accrued by the FASIT is treated as ordinary income by the ownership interest holder.

A very significant feature of the FASIT rules is that the taxable income of the holder of an ownership interest (or a high-yield regular interest) for any tax year cannot be less than the sum of the holders taxable income determined solely with respect to such interest (including gains and losses from sales and exchanges of such interest) and the "excess inclusions" from REMIC residual interest investments for such year. For example, if the outside deductions are $200 and FASIT taxable income is $100, taxable income for the year is deemed to be $100; however, an NOL in the amount of $200 is created that is generally available for a three-year carback or a 15-year carryforward. Additionally, there are special rules relating to the interplay of these rules and the alternative minimum tax computation. There does not appear to be any limitation on the use of tax credits to the extent otherwise available against a tax liability created by, the FASIT no-outside-deduction or REMIC excess-inclusion rules.

Taxation of Regular Interest


Amounts includible in gross income with respect to a regular interest in a FASIT shall be determined under an accrual method of accounting. Accordingly, a cash-basis investor will be converted to the accrual method for purposes of computing income from such investment.

Particular attention should be given to the rule that the taxable income of the holder of a high-yield regular interest shall in no event be less than the sum of the taxable income determined solely with respect to such interest (including gains and losses from sales and exchanges of such interests) and the excess inclusion income from REMIC residual interest investments.

Any transfer of a high-yield regular interest will be disregarded if the interest is transferred to a disqualified holder (any person other than a domestic C corporation, another FASIT or certain securities dealers). The last eligible holder will be required to include the gross income attributable to the interest. There are no limitations on who may hold a regular interest.

Other Special Rules

Sponsors cannot avoid the high-yield regular interest rules by creating a synthetic high-yield interest in a passthrough entity. If the principal purpose of the arrangement was the avoidance of the high-yield regular interest rules, a tax is imposed at the highest corporate rate on the passthrough entity on the income attributable to the regular interest.

Apparently, a FASIT may be terminated either through a voluntary termination with IRS consent or an inadvertent termination due to a failure to meet the requirements for continued FASIT treatment. The termination of a FASIT becomes effective on the date of the termination.

Rules similar to the special wash sale rules applicable to REMIC residual interests will apply to the ownership interest in a FASIT. The legislative reports provide that an ownership interest in a FASIT and a residual interest in a pool of debt obligations substantially similar to the debt obligations in the FASIT will be treated as substantially identical stock or securities. Like the rule applicable to REMICs, the blackout period is six months before and six months after the date of sale. Note that the special wash sale rules do not apply to FASIT high-yield regular interests despite their perceived equity flavor.

Finally, for the creative who have already identified several areas of potential tax arbitrage, there is an anti-abuse rule to prevent the use of the FASIT provisions for other than the intended purpose of asset securitization. See the charts for a summary of the advantages (on page 141) and disadvantages (on page 142) of a FASIT.

The FASIT provision takes effect on Sept. 1, 1997. The SBJPA provides a special transition rude for entities in existence on Aug. 31, 1997 (such as a trust whose interests are taxed as a partnership) that elect to be FASITs.

From Anthony Donadio, CPA, J.D., LL.M., and Mark Leeds, New York, N.Y, with helpful comments by Martin J. Rosenblatt, CPA, Jeffry B. Seidel, CPA, and Terence B. Meyers, CPA, J.D.,New York, N.Y.

Advantages of FASIT

1. No entity-level tax is imposed on a FASIT.

2. There is no minimum equity requirement. This allows a greater amount of assets to be monetized through the issuance of debt.

3. FASIT regular interests are treated as debt for all Federal tax purposes. Certainty as to debt treatment for noninvestment grade and subordinated interests will create greater efficiencies and flexibility in debt issuances.

4. There is flexibility as to the types of qualifying assets that may be held by the FASIT.

5. A FASIT has flexibility in distributing and releasing assets.

6. There is great flexibility as to the timing of transfers and substitutions of assets.

7. Potential application of the publicly traded partnership rules are avoided.

8. There is flexibility as to the legal form of the issuing entity.

9. Pre-effective date FASITs may avoid or defer tax on transfer.

10. Hedging instruments can be held directly by the FASIT.

11. Flexibility as to form may reduce structuring and administrative costs, such as the need for an indenture trust.

12. A FASIT election is optional and allows the decision as to structure to be based on a comparison of the economics of alternative structures.

13. For financial accounting purposes. FASIT transactions may be treated as sale transactions (subject to consolidation rules). While it is subject to the gain recognition rules for tax purposes, the transaction is treated as a financing.

14. A FASIT election does not have to be made in the initial y ear and can be made for an existing qualifying entity.

15. By being more fungible and hence more liquid, FASIT regular interests may expand the asset securities market.

16. A FASIT can issue debt at any time. This ability to continually issue debt allows the securitization of revolving loan accounts.

Disadvantages of a FASIT

1. Gain is immediately recognized on asset transfer regardless of whether the sponsor retains an interest in the assets. The gain is a timing difference recovered through tax amortization of the assets.

2. There is a special valuation rule for nontraded assets, which may create an artificial gain amount on the transfer to a FASIT.

3. Assets held outside the FASIT that support FASIT regular interest will be subject to the same gain recognition rules as assets actually transferred to the FASIT.

4. Losses are not recognized by an ownership interest holder (or related person) on a transfer of assets to the FASIT.

5. Related persons who transfer assets to a FASIT or hold assets that support a FASIT regular interest are subject to the special gain valuation rules, which may create artificial gain.

6. The ownership interest may be held by only one person and that person must be a domestic C corporation.

7. Taxable income attributable to either high-yield regular interests or the ownership interest cannot be offset by outside deductions.

8. Broad wash sale rules apply to the sale of the ownership interest.

9. For high-yield regular interests, qualified investors are limited to domestic C corporations, other FASITs and, in certain other cases, dealers in securities.

10. Upon termination of a FASIT, a regular interest that would not qualify as debt under general tax principles may trigger cancellation of indebtedness income.

11. Income from assets must be computed on a constant yield to maturity method, taking into account prepayments.

12. Tax from prohibited transactions is imposed directly on the ownership interest holder.

13. Tax-exempt interest is converted to taxable income if held by the FASIT.

14. To the extent the mark-to-market rules of Sec. 475 applied to assets before a transfer to a FASIT, the rules will continue to apply after the transfer. For nontraded assets, the special valuation rules may inflate value.
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Title Annotation:financial asset securitization investment trust
Author:Leeds, Mark
Publication:The Tax Adviser
Date:Mar 1, 1997
Previous Article:IRS issues guidance on the treatment of a trust as foreign or domestic.
Next Article:Inflation-indexed debt instruments.

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