United States: The Taxation Of CLO Risk Retention Structures

By Jason Schwartz, Jean Bertrand, and Sejin Park*

I. Introduction

In the wake of the 2007–2008 global financial crisis, the United States and Europe enacted "risk retention" rules that require sponsors of securitization vehicles to maintain a financial interest in those vehicles (i.e., "skin in the game"). This article examines one tax structure that U.S. collateral managers of collateralized loan ob- ligation issuers ("CLOs") commonly use to comply with these rules. At the heart of this structure is an entity called a capitalized management vehicle, or "CMV." On February 9, 2018, the U.S. Court of Appeals for the D.C. Circuit held that U.S. collateral managers of CLOs are not "securitizers" and therefore are not required to retain a financial interest in the CLOs under the U.S. risk retention rules.¹ However, whether or not the government appeals this decision, U.S. collat- eral managers of CLOs must continue to comply with the European risk retention rules (which, as discussed below, are similar to the U.S. rules) if they want the CLOs to be able to issue notes to certain European investors. Moreover, U.S. collateral managers that have already set up CMVs to comply with the U.S. rules might, as a practical matter, be locked into their structures for a considerable period of time to come.

As described in greater detail below, to comply with the risk retention rules, many U.S. collateral managers orga- nize a CMV, which is treated for U.S. tax purposes as a partnership between themselves and third-party investors. The CMV manages CLOs and uses money contributed primarily by the third-party investors to acquire interests in the CLOs. In exchange for their cash contribution to the CMV, the third-party investors are entitled to receive (1) the regular investment return on the CLO interests that the CMV acquires, which consists of payments made in respect of those interests pursuant to the priority of payments contained in the CLO's indenture, plus (2) an "increased return" on the most subordinated class of interests (which are commonly referred to as the "subor- dinated notes") that the CMV acquires. The increased return effectively compensates investors in the CMV for serving as indirect "anchor investors" in the CLOs² and is payable as a result of a corresponding reduction in the management fees that the CMV charges the CLOs.

Third-party investors who are foreign persons for U.S. tax purposes would be subject to U.S. income tax if any part of their allocable share of income from the CMV were characterized as fee income from services performed within the United States (i.e., U.S.-source management fees). Accordingly, U.S. tax advisors reviewing proposed risk retention structures must ensure that third-party foreign investors in the CMV are allocated solely investment returns, and not fee income.

The stakes are high: CLOs are consistently the largest non-bank investors in commercial loans. A general in- ability of U.S. collateral managers to comply with the risk retention rules could dramatically reduce credit availability for U.S. and European companies and increase their fi- nancing costs. Moreover, CLOs are an important source of fee income for many U.S. collateral managers.

Part II of this article briefly explains what a CLO is.³ Part III summarizes the application of the risk retention rules to CLOs and provides an overview of a typical CMV structure. Part IV explains why the foreign entity through which foreigners invest should not be subject to U.S. income tax. Part V discusses the use of a Delaware corporation to "block" certain income.

II. What Is a CLO?

CLOs are actively managed special purpose vehicles that issue notes primarily to institutional investors and use the proceeds primarily to acquire broadly syndicated commercial loans. Interest and, after a specified reinvest- ment period of four to five years, principal received by CLOs on their assets are used to pay interest and principal on the notes that the CLOs issue. CLOs hire collateral managers to manage their assets in exchange for management fees.⁴

CLOs usually are treated as foreign corporations for U.S. tax purposes and usually are organized in the Cayman Is- lands, which does not impose an income tax, or in Ireland, the Netherlands, or Luxembourg, which permit interest deductions on the CLO notes to effectively eliminate any home jurisdiction income tax.⁵ U.S. collateral managers comply with "U.S. tax guidelines" that allow the CLO to satisfy a safe harbor that ensures that the CLO is not engaged in a U.S. tra e or business and is not subject to U.S. net income tax.

Foootnotes

* The authors would like to thank Linda Swartz, Gregg Jubin, and Adam Risell for their valuable contributions to this article. Linda Swartz is a partner in the Tax Group of Cadwalader, Wickersham & Taft LLP. Gregg Jubin is a partner, and Adam Risell is an associate, in the Capital Markets Group of Cadwalader, Wickersham & Taft LLP.

1 The Loan Syndications & Trading Ass'n v. SEC, No. 17-05004, 2018 WL 798290 (D.C. Cir. Feb. 9, 2018).

2 As discussed in Part IV.C., anchor investors in CLOs have historically negotiated to receive a better return on their investment than other investors.

3 For a detailed discussion of the taxation of CLOs, see Jason Schwartz & David S. Miller, Collateralized Loan Obligations, 6585-1st Tax Mgmt. Port. (BNA) (2018).

4 Management fees typically consist of (1) the "senior management fee," which is senior to payments on the CLO's notes and typically equals 0.15–0.20% annually of the face amount of the CLO's assets; (2) the "subordinated management fee," which is junior to payments on all but the CLO's most subordinated class of notes and typically equals 0.20%–0.35% annually of the face amount of the CLO's assets; and (3) the "incentive management fee," which is typically a 20% residual interest in the CLO's net profits that is payable pari passu with the CLO's most subordinated class of notes, but only after that class has achieved a specified internal rate of return (commonly 8–12%).

5 CLOs managed by U.S. collateral managers typically are organized in the Cayman Islands.

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