One of the reasons why companies use trusts is to place selected assets or liabilities off balance sheets. However, careful planning is required to achieve this goal. This article examines the treatment of securitisations and employee benefit trusts.
There is a continuing debate as to whether a charitable trust can be used to achieve an effective independent entity or whether it is better to use one of the burgeoning purpose trust regimes that are now on offer. Of even more importance is what the correct accounting treatment for such transactions should be.
The process of a securitisation is relatively straightforward. It involves the establishment of a special purpose vehicle under a trust. The special purpose vehicle (the issuer) will issue loan notes backed by certain receivables or possibly other assets sold to it by the original lender (the originator).
More recent securitisations by UK entities have involved other debts such as credit card receivables. Added complications arise because the term of the notes may greatly exceed the expected term of the receivables. This gives rise to issues as to the terms on which replacement assets are provided by the originator to the issuer, and how losses of these assets are shared between the parties concerned. A securitisation is only likely to be effective in transferring the assets off balance sheet if the risks of loss are transferred to the issuer.
Often the originator of the assets will be a bank and as such subject to regulation in its home country. A key objective will be to ensure that following securitisation it can exclude the assets concerned from those against which it has to allocate capital. This is not quite the same as the asset going off balance sheet and separate rules apply. In the case of a UK banking institution the rules that apply are those laid down by The Bank of England in its notices to institutions authorised under the Banking Act 1987.
Retention of Surplus
Overlying all of this will be a desire by the originating company to retain the benefit of any operating surplus arising from the assets concerned. It may retain the right to determine the return on any securities issued by the vehicle, or the rate of interest payable by the vehicles debtors. A variety of techniques may be used to achieve these objectives each of which will have their own tax, accounting and regulatory implications. A summary of the methods commonly used in the UK are shown below.
The issuer and originator exchange loans. The rate of interest payable by the originator is sufficient to ensure that the issuer can pay the interest on the loan notes that it issues. The rate of interest paid by the issuer is variable, but effectively transfers any surplus of the interest paid by the debtors over the issuer's outgoings to the originating company.
Interest Rate Swaps
Reciprocal payments are made between the originator and the issuer by reference to notional amounts of loan capital with the same objectives as with the reciprocal loans. Alternatively a payment may be made in one direction only, which represents the difference between two notional rates applied to a notional capital sum.
Management or Arrangement Fees
The issuer may pay a fee to the originator which effectively leaves the issuer with little or no profit and little or no loss.
The originator may assign only so much of the entitlement to receive interest or, in some cases, entitlement to receive interest and debt repayment, as it leaves the issuer with little or no profit or loss. In some cases an equitable interest in predetermined proportions in the entire entitlement to interest and debt repayment may be acquired by a trust for the benefit of the originator and the issuer.
Onshore Versus Offshore
The decision as to whether the issuer should be located offshore or onshore will often depend on tax considerations. Where the securitisation involves UK mortgage or lease receivables it is likely that the issuer will have to be resident for tax purposes in the UK. This will apply in the case of mortgage receivables in order to avoid an exposure to withholding tax in the UK and, in the case of lease receivables in order to avoid the risk of the issuer having a branch, and hence a wider tax liability, in the UK. However, in other cases where, for example, the receivables are short-term it is possible for the issuer to be located offshore. Doing so can avoid the various UK tax complications.
Where the income from the receivables is subject to deduction of tax it may still be possible to locate the issuer offshore by transferring the risk in the assets to the issuer under a derivative arrangement, such as a subparticipation agreement rather than by way of an outright assignment. Provided that this arrangement is structured properly it may be possible to avoid the incidence of withholding tax in the UK whist still achieving the desired balance sheet effect.
Do The Assets Go Off Balance Sheet?
There are three separate factors which have to be taken into account in determining whether the assets will go off balance sheet. First, the relevant company law considerations; second, the relevant accounting pronouncements; and third, where applicable, the relevant regulatory rules.
Following changes made by the UK Companies Act 1989, it is possible for an undertaking to be a subsidiary of a UK company even if the parent has no shareholding. Whether or not the UK company is regarded as a parent depends on whether it can exercise a dominant influence over the undertaking either:
- by virtue of provisions contained in the undertaking's memorandum or articles of association: or
- by virtue of a control contract.
Thus in the case of a UK originator it is possible that the terms on which the originator provides and subsequently monitors the assets belonging to the issuer will result in the issuer being regarded as a subsidiary of the originator for UK Companies Acts purposes.
There is a risk that the issuer is regarded as a quasi subsidiary. If so it will be necessary for the balance sheet of the issuer to be included in the group accounts of the originator.
Financial Reporting Standard 8 defines a quasi subsidiary to be a vehicle directly or indirectly controlled by the reporting entity that gives rise to benefits for the entity that are, in substance, no different from those that would arise if the vehicle were a subsidiary. A quasi subsidiary can include a trust, partnership or any other vehicle and control is defined as the ability to direct the financial and operating policies of any entity with a view to gaining economic benefit for its activies.
Inclusion in the group financial statements is necessary in order to give a true and fair view of the group. Failure to do so would result in the accounts not complying with the Companies Acts. However, this requirement is rarely encountered in practice because, where the issuer is regarded as a quasi subsidiary, it will generally be necessary for the issuer's assets and liabilities to be recorded in the originator's own balance sheets.
The Originator's Own Accounts
As far as the originator's own balance sheet is concerned there are three possible treatments.
i) De-recoginition: neither the securitised assets nor the associated loan notes need to be recorded in the originator's balance sheet.
ii) Linked presentation: the proceeds of the loan notes are deducted from the securitised assets on the face of the balance sheet within a single balance sheet caption.
iii) Separate presentation: the gross amount of the securitised assets and the associated loan notes are shown separately in the balance sheet.
De-recognition is only appropriate where the originator retains no significant benefits and no significant risks relating to the assets and it is likely that this will be the exception.
Linked presentation is permitted where although the originator has retained significant benefits and risks relating to the securitised assets, there is absolutely no doubt that its downside exposure to loss is limited to a fixed monetary amount.
Where the conditions for either de-recognition or linked presentation are not met a separate presentation will be required with the result that the securitised assets do not go off balance sheet.
The ability to account on a linked basis is something of a triumph of reason over technical structure and the solution adopted in FRS of applying the treatment previously reserved for non-recourse funding (i.e. the linked presentation) to securitised assets has prevented the securitisation process from becoming moribund.
The Bank of England’s policy allows the use of securitisations to remove assets from the risk/asset ratio of a UK banking institution but to keep a tight check on the credit exposures that remain with the originator.
It also ensures that the securitisation arrangements result in a full sharing of risk by the loan note holders throughout the period of the securitisation and that the requirements that have to be satisfied in order for the assets to be removed from the bank's risk/asset ratio calculation are aimed at achieving this objective.
In the case of securitisations of revolving credit receivables, such as credit card receivables the Bank of England will look at the condition under which the scheduled repayment of the loan notes can be made and the events which can trigger an early repayment. The terms of the securitisation can permit the originator to have a "clean-up" call option over the receivable, ie an option to repurchase the rump of the receivables remaining after the majority have been repaid. However, the option cannot apply to more than ten per cent of the receivables at the start of the period of authorisation.
Prior to April 1996 banks could only remove revolving credit receivables from their risk asset ratio representing up to ten per cent of their capital base through securitisation. There is now no longer a fixed limit.
Employee Benefit Trusts
By contrast, the recent accounting pronouncement affecting employee benefit trusts is not so helpful. Legislation in a number of countries allows companies to provide financial assistance for the purchase of their own shares for the purposes of an employee share scheme.
Key to any UK share ownership plan is an employee benefit trust, which is set up to purchase and hold the shares. These trusts are financed either by a loan from the company (usually interest free) or by a bank loan or by a combination of the two. Where a bank is involved, the company will directly or indirectly underwrite the obligations of the trust. Employees may be granted options over the shares held by the trust, or the shares may be held with a view to transferring them to employees in the future either through the grant of options or by gift under a profit-sharing scheme.
The guidance given by the Accounting Standards Board in UTIF Abstract 13 is that, whenever the sponsoring company has de facto control of shares held by an employee benefit trust, the shares and related funding have to be accounted for in the balance sheet of the sponsoring company. In the view of the Accounting Standard Board this will be in the majority of cases.
The practical implications of this is that companies who set up employee benefit trusts are required to record the shares concerned on their balance sheet either in place of the loan to the employee benefit trust (where the employee benefit trust is funded by the company) or with a matching liability to the bank (where the employee benefit trust is funded by a bank loan). A provision will be required for any fall in the value of the share below their book value if the reduction is permanent or possibly, if it is substantial and persistent. This treatment is similar to that required of ESOPs in the US.
The financing costs are written off as expenses as they accrue whilst the expense of any shares which are transferred by way of gift to employees or the expense of granting options at below book value is recognised by writing down the shares over the period of service to which the expense relates. The timing of the relevant tax deduction is likely to be similarly deferred.
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