United States: The Taxation Of CRE-CLOs

Last Updated: September 13 2018
Article by Jason D. Schwartz, Gary T. Silverstein and Daniel Ng

Most Read Contributor in United States, August 2018

INTRODUCTION

Commercial real estate collateralized loan obligations (CRE-CLOs) are growing in popularity as a way to securitize mortgage loans. Market participants have predicated as much as $14 billion of new CRE-CLO issuances in 2018,1 compared to $7.7 billion in 2017.2

In many ways, CRE-CLOs are a more flexible financing option than real estate mortgage investment conduits (REMICs), the traditional vehicles for commercial mortgage-backed securitizations. Unlike RE- MICs, CRE-CLOs may hold mezzanine loans, ''delayed drawdown'' loans, and ''revolving'' loans (and, in some cases, preferred equity), may borrow against a managed pool of assets, and may have more liberty to modify and foreclose on their assets. But structuring a CRE-CLO is not without challenges, and failing to properly structure a CRE-CLO could create adverse tax consequences for investors and could even subject the CRE-CLO to U.S. corporate tax.

This article discusses the tax considerations applicable to CRE-CLOs: what a CRE-CLO is; the overarching tax considerations relevant to CRE-CLOs; the two most common CRE-CLO tax structures — the qualified REIT subsidiary (QRS) and the foreign corporation that is not a QRS; and the material benefits of using a CRE-CLO instead of a REMIC to securitize mortgage loans.

WHAT IS A CRE-CLO?

CRE-CLOs are special purpose vehicles that issue notes primarily to institutional investors, invest the proceeds mainly in mortgage loans, and apply the interest and principal they receive on the mortgage loans to pay interest and principal on the notes that they issue. CRE-CLOs allow banks, real estate investment trusts (REITs), and other mortgage loan originators to sell their mortgage loan portfolios, freeing up capital that they can then use to make or acquire additional mortgage loans. By issuing multiple classes of notes with different seniorities and payment characteristics backed by a pool of mortgage loans, CRE- CLOs appeal to investors that may not be willing or able to invest directly in mortgage loans.

OVERARCHING TAX CONSIDERATIONS

Taxable Mortgage Pool Rules

Under the taxable mortgage pool (TMP) rules of the Internal Revenue Code, a vehicle (other than a REMIC) that securitizes real estate mortgages is treated as a TMP and taxed as a separate corporation for U.S. tax purposes if it issues two or more classes of ''debt'' with different maturities and the payment characteristics of each debt class bear a relationship to payments on the underlying real estate mortgages.3 The TMP rules are intended to subject any net income recognized by a domestic mortgage loan securitization vehicle — i.e., the positive difference between interest accruals on the vehicle's assets, on one hand, and interest accruals on the vehicle's obligations, on the other hand — to U.S. net income tax.4 (If the vehicle is a REMIC, no entity-level tax is imposed, but holders of a special class of ''residual interests'' must pay this tax, and the ''excess inclusion'' rules discussed below prevent all or a portion of the taxable income from being offset or otherwise eliminated.) Because CRE-CLOs typically issue more than two classes of notes, they generally will be TMPs.

Avoiding Entity-Level Tax

As a condition to assigning a credit rating to any notes issued by a CRE-CLO, rating agencies typically insist that the CRE-CLO receive an opinion from U.S. tax counsel that the CRE-CLO ''will not'' be subject to an entity-level tax in the United States. Investors also expect this opinion, because a layer of corporate tax could dramatically reduce their investment returns.

Under §11(b), domestic entities that are treated as corporations for U.S. tax purposes generally are subject to a 21% net income tax. In addition, under §882, foreign entities that are treated as corporations for U.S. tax purposes are subject to U.S. federal income tax on any income that is ''effectively connected'' with the conduct of a ''trade or business'' within the United States.

Accordingly, to avoid U.S. entity-level tax, CRE- CLOs generally are structured as one of the following:

  • Qualified REIT Subsidiary (QRS CRE-CLO). REITs are a special type of domestic corporation that invest predominantly in real estate assets, including real estate mortgages, and generally can eliminate U.S. corporate tax by distributing all of their net income to their shareholders on a current basis. Because of their investment strategy, REITs are common sponsors of CRE-CLOs.

    Under the REIT rules, if a REIT owns all of the equity interests in another corporation (which is referred to as a qualified REIT subsidiary, or QRS), then (absent an election otherwise) the QRS's assets, liabilities, and items of income, loss, and deduction are treated as the assets, liabilities, and items of income, loss, and deduction of the REIT itself. Thus, if a CRE-CLO is established as a QRS, then the CRE-CLO will not be subject to U.S. corporate tax, even if it is also treated as a TMP (i.e., even though it is a QRS-TMP). Instead, for U.S. tax purposes, the REIT is treated as the direct owner of the QRS's investment portfolio and is treated as pledging the portfolio as collateral for the notes that the QRS issues.

    To maintain its status as a QRS, a CRE-CLO must ensure that all of its ''tax-equity'' is beneficially owned by a single REIT.
  • Foreign corporation that is not a QRS and is not engaged in a U.S. trade or business (non- QRS CRE-CLO). A CRE-CLO that does not qualify as a QRS typically is organized in the Cayman Islands, which does not impose corporate income tax, and complies with ''tax guidelines'' to ensure that it is not engaged in a U.S. trade or business and thus is not subject to U.S. net income tax under §882. Although tax guidelines generally limit a CRE-CLO's origination and workout activities, a non-QRS CRE-CLO can issue tax-equity to outside investors (which a QRS CRE-CLO cannot do).

QRS CRE-CLOS: SPECIAL TAX CONSIDERATIONS

Limitation on Issuing Tax-Equity

A QRS is a corporation whose ''tax-equity'' is 100% owned by a REIT. CRE-CLOs issue multiple classes of notes into the capital markets with different seniorities. Accordingly, in order to opine that a CRE- CLO ''will not'' be subject to an entity-level tax in the United States on the basis that it is a QRS, U.S. tax counsel require a REIT to retain any classes of notes issued by the CRE-CLO that could be treated as equity for U.S. tax purposes — i.e., that do not receive an opinion that they ''will'' be treated as debt for U.S. tax purposes. This retention requirement is one of the most limiting downsides of using a QRS CRE-CLO instead of a non-QRS CRE-CLO.5

Whether an instrument is treated as debt or equity for U.S. tax purposes depends on the facts and circumstances on the instrument's issue date, and no one factor is determinative.6 Numerous publications discuss these factors at length.7 However, one important factor is the reasonable likelihood of timely payment of principal and scheduled interest on the instrument.

A note's credit rating is generally viewed as indicative of its likelihood of repayment, and U.S. tax counsel typically do not opine that a class of notes will be treated as debt for U.S. tax purposes unless that class receives an investment grade credit rating — e.g., Baa3 or higher from Moody's, or BBB- or higher from Fitch. Accordingly, QRS CRE-CLOs generally may not issue below-investment-grade notes or equity to third-party investors. Instead, these interests must be retained by the REIT (or any entity disregarded into a REIT).

Footnotes

1 Cathy Cunningham, CREFC 2018: Say Hello to CLOs, Commercial Observer (Jan. 11, 2018).

2 New Sponsors to Lift CLO Volume This Year, Commercial Mortgage Alert (Feb. 9, 2018), at 4.

3 See §7701(i). Exceptions exist for entities that issue classes that are subordinated only with respect to credit risk. See Reg. §301.7701(i)-1(e). These exceptions are beyond the scope of this article.

All section references are to the Internal Revenue Code of 1986, as amended (Code), and the regulations thereunder, unless otherwise specified.

4 See Reg. §301.7701(i)-1(a) ("The purpose of section 7701(i) is to prevent income generated by a pool of real estate mortgages from escaping [f]ederal income taxation when the pool is used to issue multiple class mortgage-backed securities.").

5 If the sponsor is not already a REIT, then creating and maintaining a REIT also may be a significant downside of using a QRS CRE-CLO.

6 See, e.g., John Kelley Co. v. Commissioner, 326 U.S. 521 (1946); Rev. Rul. 68-54.

7 See, e.g., Schwartz & Miller, 6585 T.M., Collateralized Loan Obligations, at II.A; William T. Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax L. Rev. 369, 370, 404–574 (Mar. 1971).

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Originally published in Tax Management Real Estate Journal

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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