Securitisation has been maturing as a significant sector in the European Union (“EU”) capital markets, encompassing a wide range of assets (from debt portfolios to residential mortgages). It inter alia enables originators to generate liquidity, shift specific risks to parties with a higher capacity to manage them and to more efficiently access capital markets (usually with better debt ratings). At the same time, it offers investors more far-reaching combinations of yield, risk and maturity, which generally better accommodate their investment strategies, as well as risk and yield appetites[1].
Securitisation can be broadly defined as the pooling of assets and their financing through the issuance of securities[2]. Typically, the pool of assets is transferred from the “Originator” to a “Special Purposes Vehicle” (“SPV”) or Securitisation Vehicle (“SV”), which finances the acquisition of such assets through the issuance of securities. The principal amount and interest (re)payments on the issued securities usually track the performance of the underlying portfolio and are collateralised by them. Moreover, the acquisition of the securitised risk may be structured via the direct transfer of the legal title over the collateralised pool of assets (from the Originator to the SV), or may be undertaken through credit derivatives (the so-called “synthetic securitisation”), pursuant to which the (credit) risk over the underlying portfolio is transferred to the SV through derivatives such as credit default swaps or total return swaps, the legal title over the underlying portfolio remaining with the Originator.
The credit risk associated with the (pool of) exposure(s) is typically split into tranches serving different risk profiles and being subject to “waterfall” payment sequences, which hierarchise the use of the cash returns on the underlying portfolio across the several tranches. Whilst tranching is required for the qualification of a given transaction as “securitisation” under Article 2(1) of the Regulation (EU) 2017/2402 of 17 December 2017[3], some EU jurisdictions have broader definitions of securitisation which therefore do not fall within the scope of the Regulation at hand[4].
From a tax standpoint, SVs (with a corporate legal form) are usually subject to standard corporate tax rules, with the particularity that generally commitments towards creditors and equity investors (even if to be paid-out as a return on capital/dividends) qualify as operating expenses and are, therefore, tax-deductible. SVs are nonetheless subject to the measures of the Council Directive (EU) 2016/1164 of 12 July 2016 (“ATAD I”). Particular emphasis should be given in this respect to Interest Limitation Rules (“ILR”), to the extent that these may impact the deductibility of the commitments (assumed to qualify as “borrowing costs”, within the meaning Article 2(1) of ATAD I) and, equally (if not mostly importantly), of the interest charges (or economically equivalent) on the securities issued by the SV. Indeed, to the extent that ILR apply[5], the deductibility of the SVs’ exceeding borrowing costs (broadly computed as the difference between the SV’s borrowing costs and its interest income or economically equivalent revenues[6]) would be capped to 30% of its earnings before interest, tax, depreciation and amortisation (“EBITDA”) or 3 million euros (“EUR”), whichever is higher (cfr. Articles 4(1) and 4(3)(a) ATAD I).
Whilst ILR are not expected to adversely impact SVs if the interest charges on their securities are perfectly matched by interest income or economically equivalent on their underlying portfolio (such that their exceeding borrowing costs are nil), this is not always the case.
- Taxable income other than interest income or economically equivalent
Should a given SV realise taxable income other than interest (or economically equivalent), it may be that its borrowing costs end up not being symmetrically netted-off, potentially resulting in the non-deductibility of a big portion of its interest expenses.
The cases of distressed debt/non-performing loan (“NPL”) portfolios acquired by SVs are paradigmatic in this respect. It is indeed not always clear-cut whether the return generated upon repayment (or disposal) of the debt instrument (acquired below par value) once the financial situation of the debtor improves qualifies as interest income (or economically equivalent) or rather as a (capital) gain. In line with paragraph 35 of the BEPS Action 4 Report, interest income, in its barest form, shall correspond to the remuneration for the “time value of money”, the agreed quantum of the remuneration being factored per time unit (with either a fixed or variable percentage) and in considering inter alia the credit-worthiness of the borrower, market conditions for lending, etc. The return generated upon repayment/disposal of NPLs though is more speculative in nature, carrying out an element on uncertainty linked to the intrinsic (potential) fluctuations of their fair market value (“FMV”).
Whilst dependent on the specific accounting treatment, the valuation of NPLs might be based on their expected recovery upon acquisition of the portfolio by the SV. Typically, the difference between the excepted recovery valuation and the acquisition cost of the NPLs would correspond to the maximum amount that could be qualified as interest income (or economically equivalent), the exceeding portion (if any) corresponding to a capital gain[7] (which could not offset any borrowing costs).
- Timing mismatches
Similarly, timing mismatches between the payment of interest charges on the issued securities and the receiving of interest income (or economically equivalent) on the underlying portfolio (namely if not accruing on the same tax year) could potentially expose the SV to ILR.
Standalone entity exception
Ensuring that the SV is in perfect back-to-back and maintaining its symmetrical position throughout the lifetime of a given structure may not always be feasible, as outlined above. Nonetheless, there have been ongoing discussions in tax literature as to whether ILR’s standalone entity exception may, to some avail, rule out the applicability of the deductibility of cap foreseen in Article 4 ATAD I and consequently prevent operational burden in managing the qualification of a given portfolio’s return, as well as the need to ensure symmetrical treatment between the SV’s interest payables and receivables.
The standalone entity exception, foreseen in Article 4(3)(b) ATAD I, applies to taxpayers which:
- Are not part of a consolidated group for financial accounting purposes, understood as “all entities which are fully included in consolidated financial statements drawn up in accordance with the International Financial Reporting Standards or the national financial reporting system of a Member State” (cfr. Article 4(8) ATAD I)[8];
- Have no associated enterprise, i.e., no entity/individual which, directly or indirectly, holds a 25% participation or more (in terms of capital ownership, voting rights and profit entitlement) in the taxpayer at stake (Article 2(4)(b) ATAD I)[9]; and
- Have no permanent establishment.
The question of whether the standalone entity exception applies or not is particularly relevant given that securitisation transactions are often organised via “orphan structures”, where the shares of the SV are typically owned by a third party (often a charitable trust or foundations like Dutch Stichtings), which acts the share trustee on behalf of certain beneficiaries[10]. Usually, the returns on the underlying portfolio are transferred to the investors which subscribed the securities issued by the SV, such that the trust receives neglectable profits (if any)/capital return upon collapsing of the structure.
The analysis of the standalone entity exception is nevertheless not as straightforward as it may seem at first sight; particularly, the “associated enterprises test” gives rise to a couple of complexities mainly arising at the following levels.
- At the level of the trust
Prima facie, the trust wholly owns the legal title over the SV’s capital, such that it should automatically be considered as an associated enterprise. The following may nevertheless be questioned:
- Does the trust qualify as an entity for the purposes of the “associated enterprise” test referred to in Articles 4(3)(b) and 2(4)(b) ATAD I? Trusts are three-party fiduciary relationships, the question posing as to whether a flow-through approach should be undertaken, and the underlying beneficiaries investigated (to ultimately perform the “associated enterprise” test at their level).
- Whilst the trust is the legal owner of the SV’s shares, it is not clear-cut whether it effectively exercises control over the economic ownership of the underlying portfolio. ATAD I is silent as to whether economic ownership should prevail over the legal title for the purposes of the “associated enterprise” test, though tax literature and case law across several EU Member States tend to embrace a substance/economic over form approach, which could potentially play a role at this level[11]. Arguably, the trust cannot exercise voting rights over the shares held, does not ultimately bear the risks stemming from the underlying portfolio, namely related to changes in its valuation, nor has effective entitlement over the upsides/downsides on the SV’s shares. Rather, the beneficiaries of the trust would qualify as the (economic) owners of the SV’s capital, meaning that the “associated enterprise” test would have to be applied at their level. Whilst theoretically it may be possible to have independent and disconnected beneficiaries in a given trust, it may be difficult in practice to ensure that there are (at least) 5 completely unrelated economic owners/beneficiaries.
- At the level of the holders of the securities issued by the SV
In principle, the SV is barred from undertaking any active management activities over the securitised pool of assets that could potentially generate an additional entrepreneurial/commercial risk on top of the pre-existent inherent risk of value fluctuations of the underlying portfolio[12]. The SVs must refrain from actively managing their assets, such that no or marginal return is usually generated and distributed to its equity shareholders; rather, incoming and outgoing cash flows generally come from/are received by unrelated parties.
The question may thus also pose as to whether the holders of the securities issued by the SV can qualify as associated enterprises, namely in case of significant security holders entitled to 25% or more of variable interest tracking the performance of the underlying portfolio.
As pointed out by some tax literature though, the “associated enterprise” definition rather refers to capital, voting rights and/or profits on the SV, and the variable yield on the securities does not depend on the accounting profits of the SV (which reflect the unrealised changes in the valuation of the underlying portfolio)[13]. The holders of the securities are technically not entitled to a share of profit, but rather to a remuneration computed as a percentage over the net income of the SV, that contractually accrues over time without a deliberate positive action being needed for the distribution to take place (e.g., a(n) (extraordinary) general shareholders’ meeting). Moreover, the variable interest charges paid up by the SV should in principle qualify as “borrowing costs” within the meaning of Articles 4 and 2(1) ATAD I, such that it would be contradictory to simultaneously qualify the variable yield received by the security holders as profits for the purposes of the same legal provisions.
The fact that the biggest part of cash proceeds flowing from the SV end up with the security holders may nonetheless raise concerns from a beneficial ownership perspective with the potential refusal of application of Double Tax Treaty (“DTT”) benefits and consequent withholding tax risks at the level of the source country/ies.
Conclusion
Whilst still a niche market, securitisation has been flourishing within the EU, aiding several businesses in obtaining higher levels of liquidity. The interplay between ILR and SVs still gives rise to some legal uncertainties though, being crucial to thoroughly clarify them since SVs tend to be largely financed with debt securities, for which the deduction of the resulting interest charges should be preserved. Whilst SVs whose borrowing costs are perfectly matched by their interest income (or economically equivalent) are not expected to be adversely impacted by ILR, operationally it may be burdensome (or even unfeasible) to monitor such symmetry, particularly when the qualification of the return flowing from some portfolios which are typically securitised (such as NPLs/distressed debt) is not straightforward. The application of the standalone entity exception comes, in this respect, into play as a possible way-out with particular relevance for SVs operated in “orphan structures”, though it seems that the exact contours of this exception end-up giving rise to even more questions, further blurring the scope of application of ILR.
Vasco Chuaqui
April 2023
[1] Securitisation in Luxembourg, a comprehensive guide, PwC.
[2] https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/financial-markets/securities-markets/securitisation_en
[3] Assuming no specific exceptions apply, such as the “specialised lending” exception (as described in article 147(8) of the Regulation (EU) 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms).
[4] For example, Luxembourg – please refer to the Luxembourg Law of 22 March 2004 on securitisation, as currently amended.
[5] Out of completeness, some EU Member States (such as Luxembourg) provided a specific carve-out for SVs covered by Article 2 of the Regulation (EU) 2017/2402 of 17 December 2017. However, the EU Commission launched an infringement procedure against Luxembourg, considering that this specific exemption was going beyond the carve-outs allowed by ATAD I. Luxembourg has, as a result, amended its domestic law by eliminating this exception (in particular, in Article 168bis of the Luxembourg Income Tax Law), taking effect for financial years starting on or after 1 January 2023.
[6] Cfr. Article 2(2) ATAD I.
[7] Luxembourg Securitisation Companies, Interest Limitation Rules and the Standalone Entity Exception, Oliver R. Hoor & Keith O’Donnell.
[8] Though the taxpayer may be given the right to use consolidated financial statements prepared under other accounting standards (cfr. Article 4(8) ATAD I second sentence).
[9] Or any entity in which the taxpayer holds, directly or indirectly, at least a 25% stake (capital, voting rights and profit entitlement) – cfr. Article 2(4)(a) ATAD I.
[10] Luxembourg Securitisation Companies, Interest Limitation Rules and the Standalone Entity Exception, Oliver R. Hoor & Keith O’Donnell.
[11] Please refer for example to the German case FG Nürnberg 7 June 2016 – 1 K 904/14 and to the Luxembourg case Cour Administrative, n°24061C, du 26 June 2008 (though here the economic ownership vs legal ownership was discussed with respect to the application of the Participation Exemption).
[12] Cfr. inter alia, PwC Securitisation in Luxembourg, a comprehensive guide and Loyens & Loeff, Luxembourg securitisation vehicles.
[13] Luxembourg Securitisation Companies, Interest Limitation Rules and the Standalone Entity Exception, Oliver R. Hoor & Keith O’Donnell.