CLOs appear to have escaped the worst of the Foreign Account Tax Compliance Act, or FATCA, which requires foreign financial institutions, including foreign banks, offshore funds and CLOs domiciled offshore, to report to the Internal Revenue Service any applicable information about their U.S. accounts.
The law was designed to combat offshore tax evasion. CLOs domiciled offshore fall under its umbrella, but, because FATCA was not contemplated when many older CLOs were issued, their legal structures leave them unable to comply with the requirements. Thus, they could have been subject to a 30% tax withholding on loan interest, principal payments or sale proceeds.
However the last substantial package of regulations necessary to implement the law, released by the IRS and Treasury Department on Feb. 20, lets most, if not all, of these vintage CLOs off the hook.
The biggest “win,” according the Loan Syndications and Trading Association, is that grandfathering now applies to CLOs that closed on or before Jan. 17, 2013, rather than Dec. 31, 2011, as originally drafted. Also, this grandfathering lasts until the CLO liquidates or terminates, rather than expiring Jan. 1, 2017. In order to be grandfathered, a CLO must qualify as a limited life debt investment entity (LLDIE). This means that it will not have to register with the IRS, obtain a global intermediary identification number (GIIN) or have any FATCA investor diligence or reporting obligations for the life of the deal (unless circumstances change and the CLO no longer qualifies as an LLDIE).
Not only are the benefits of being an LLDIE longer lasting; it is also a little easier to qualify as an LLDIE, as several of the requirements have been relaxed. While this relief was intended for CLOs that do not have the necessary language to allow them to enter into an agreement with the IRS, track down the required information and provide it to the IRS, or withhold payments downstream. However, the way it was drafted actually stopped many older CLOs from qualifying for relief. Now, market participants must confirm that the CLO’s indenture and applicable law would not authorize the trustee or other person to fulfill the compliance obligations required by FATCA.
“The 2013 final regulations’ exemption for LLDIEs was seen by many in the industry as being too narrowly drafted to be of use,” the law firm of Burt Staples & Maner stated in a March 3 client letter. “While the industry wanted more, the new regulations go at least part of the way to making the LLDIE exception more accommodating.”
The revised regulations also expand the types of assets that an entity can hold and still qualify as a LLDIE. To qualify for this this relief, substantially all of the assets must be debt instruments. This is a different distinction than that made by the Volcker Rule, which deems CLOs that hold bonds or other kinds of securities to be “covered funds,” and thus off-limits to bank investors. A CLO can hold bonds and still qualify as an LLDIE, but it is not as clear whether some more esoteric assets, such as those a CLO might obtain when loans in its portfolio are involved in a bankruptcy or restructuring, are okay.
In its client letter, Burt Staples & Maner said that the requirement that substantially all the assets consist of debt instruments is problematic especially for CLOs set up in 2007 and before, because they may now have substantial equity holdings as a result of workouts. “Of course, these are temporary regulations and open to comment and potential future changes, so stay tuned,” the letter stated.