On February 4, 2000, the Internal Revenue Service released proposed regulations concerning Financial Asset Securitization Investment Trusts ( Fasits). Fasits were authorized by statute in 1996 to provide a nontaxable securitization vehicle for all types of debt instruments, including mortgage loans. It was hailed as a potentially more flexible vehicle than Remics. The new rules, however, seem to emphasize areas where the IRS perceives there to be potential for abuse, rather than establishing flexible guidelines that would make the Fasit vehicle more useful to the securitization industry. Commentators can help Treasury fill in technical gaps and seek to better define anti-abuse situations. This article considers some highlights of the new rules that may be worthy of comment.

Formal Requirements and Anti-Abuse Rules

Qualified Arrangement. A Fasit election may only be made by a "qualified arrangement," which includes a corporation, partnership or trust or a segregated pool of assets. A Fasit may not be either a foreign entity or a U.S. entity or segregated pool if a foreign country or U.S. possession could subject its net income to tax. A Fasit must have one or more classes of debt-like "regular interests" and only one "ownership interest." The Fasit election must be made by the "eligible corporation" which owns the ownership interest in the permitted entity or segregated pool (the "Owner"). For tax reporting purposes, a Fasit is treated as a branch or division of the Owner. The IRS seeks comments on when tax rules should treat the Fasit as if it were a separate entity rather than as part of the Owner.

Anti-Abuse Rules. The proposed regulations articulate that the intention of the Fasit provisions is to "promote the spreading of credit risk on debt instruments by facilitating the securitization of those debt instruments." If taxpayers do not apply the Fasit provisions in a manner consistent with their intent based on all the facts and circumstances, the IRS can make "appropriate adjustments," including disregarding a Fasit election. This broad power to recharacterize a Fasit transaction would have a great chilling effect unless the "intent" feature is broadened significantly. If finalized, this provision would be effective February 4, 2000.

The proposed regulations also contain the following two additional specific anti-abuse rules:

* A Fasit may not own debt instruments traded on an established securities market if the debt instruments are subject to foreign withholding tax.

* If a foreign resident holds a Fasit regular interest and the Fasit holds the obligation of a "related" debtor, then interest received by the foreign resident will be subject to withholding tax.

Permitted Assets

In General. "Substantially all" of a Fasit's assets must be permitted assets after the close of a formation period. The proposed regulations define "substantially all" as at least 99% of the total adjusted bases of all assets held by the Fasit. The proposed regulations describe permitted cash equivalents and clarify and limit the scope of a Fasit's permitted debt instruments and hedges.

Cash or Cash Equivalents. The proposed regulations helpfully include under "cash and cash equivalents":

* Short-term investment-grade debt instruments with a remaining maturity of 270 days or less; and

* Shares in a U.S.-dollar-denominated money market fund.

Debt Instruments. The proposed regulations specifically allow for fixed and qualified variable rate debt instruments, inflation-indexed debt and stripped bonds, stripped coupons and grantor trust certificates representing beneficial ownership of interests in otherwise permissible debt instruments. However, the regulations do not allow:

* Equity-linked debt;

* Debt instruments that are in default because of failure of the obligor to make any required payment if there is no reasonable expectation that payments (including any penalties) will be brought current within 90 days of contribution;

* Debt of the Owner, except for investment grade Owner debt that has a term of 270 days or less;

* Debt guaranteed by the Owner, if there is the expectation that the Owner will make the payments due under the guarantee;

* Debt instruments linked to an Owner's (or related party's) credit;

* A stripped bond or stripped coupon in any of the above; and

* Debt instruments traded on an established securities market if interest on the debt instrument is subject to a tax determined on a gross basis.

Hedges and Guarantees. A hedge or guarantee is a permitted asset only if reasonably required to protect against any "risk factors" that would cause a mismatch between the amount or timing of receipts on Fasit assets (including assets it expects to hold) and the amount or timing of the Fasit's obligations (including regular interests it expects to issue). The regulations define the "risk factors" as:

* Interest rate fluctuations;

* Currency exchange rate fluctuations;

* Credit risk with respect to the Fasit's assets; and

* Prepayment risks.

A hedge or guarantee meeting this definition need not be associated with any particular Fasit asset or regular interests. The hedge or guarantee must reference either a permitted asset or a widely disseminated index or average that is designed to correlate with one or more of the risk factors. Special rules restrict the ability of a Fasit to hold hedges and guarantees issued by its Owner or a related person.

Contract Rights to Acquire Debt Instruments or Hedges. The proposed regulations contain a special rule allowing a Fasit to extend loans under a line of credit, subject to special Owner gain recognition rules at the time of the lending.

An agreement to acquire hedges or debt instruments from the Owner (or a related person) is not a permitted asset if the contract calls for the Owner (or related person) to transfer the hedge or debt instrument to the Fasit for less than: (i) fair market value, or (ii) 90% of fair market value in the case of debt instruments not traded on an established securities market, as determined under the special valuation rules for such debt instruments.

Taxation of Ownership Interest Holder

Tax Reporting. The Owner must report all assets, liabilities, income, gains, deductions, losses and credits of the Fasit on its own return. The Fasit must use the constant yield method in accounting for debt instruments and must use a method of accounting for hedges that clearly reflects income and complies with the notional principal contract regulations. Any gain or loss realized on a permitted hedge is treated as ordinary. An Owner that is subject to mark to market accounting is required to mark the assets immediately prior to its contribution to the Fasit, but mark-to-market accounting does not apply to any permitted asset while it is held by the Fasit.

Transfer Restrictions. Under a proposal applicable to REMIC residual interest as well as Fasit ownership interests, a safe harbor for an effective transfer of a "noneconomic" residual interest will be met only if the transferor pays the transferee adequate consideration, generally using an arm's length Treasury rate to discount future tax costs and savings. Unless clarified, this rule could apply as early as February 4, 2000.

Gain Recognition on Transfers by the Owner to the Fasit. The Owner must recognize gain (and may not recognize loss) on the transfer of assets to the Fasit. Gain is to be calculated based on the fair market value of assets traded on an "established securities market" at the time of contribution. All other debt instruments are valued under a special rule using a discount rate that potentially overstates the actual value of the asset. The proposed regulations specify that, in addition to taking into account reasonable servicing expenses, the prepayment and loss assumptions used by the Owner for the special valuation generally must match those used in marketing the Fasit regular interests or as presented to the rating agencies or in other governmental filings. Failure to maintain this consistency gives the IRS the right to disregard any prepayment and loss assumptions in recalculating the fair market value under the special valuation rule. The proposed regulations would provide relief from this special valuation in the case of debt instruments purchased solely for cash in an arm's length transaction contemporaneously with the transfer to the Fasit.

Transfers to the Fasit by Related Parties. In the case of property subject to the special valuation rule that is contributed to the Fasit by a person related to the Owner, the related person is treated as transferring the property to the Owner for its fair market value determined under general tax principles. The Owner is then treated as contributing the property to the Fasit under the special valuation rule. This allocates gain (or potentially loss) to the related person up to (or down to) the fair market value, and then allocates gain to the Owner equal to the difference between the "general tax principles" fair market value and fair market value determined under the special valuation rule.

Support Property. Property held outside the Fasit that "supports" Fasit regular interests is also subject to the special gain recognition rule. The proposed regulations specify that support property is any property that the Owner or a related person:

* Has pledged to the Fasit or otherwise identified as providing security for the payment of Fasit regular interests;

* Has set aside for transfer to the Fasit; or

* Holds if the asset is subordinate to an asset held by the Fasit.

Fasit Owner's Income Determination. An Owner's overall taxable income may not be less than its Fasit income, i.e., non- Fasit losses cannot be used to reduce Fasit income. Somewhat unexpectedly, the gain on contribution to a Fasit would now be subject to this rule. The proposed regulations provide, however, that an Owner of multiple Fasits may aggregate ongoing net income or losses from all Fasit ownership interests.

Prohibited Transactions

The proposed regulations focus on two of the statutory prohibited transactions, income from which is subject to a 100% excise tax.

Loan Origination. A Fasit may not "originate" a loan. A Fasit is considered not to have originated a loan if it acquires the loan:

* On an established securities market;

* On a date more than 12 months after the loan was issued; or

* From a person (including the Owner or a related person) that regularly originates similar loans in the ordinary course of its business.

Unless the Fasit acquires the loan from such a regular originator, however, it will be considered to originate a loan if it engages in or "facilitates" any of the following activities:

* Soliciting the loan;

* Evaluating the borrower's financial condition;

* Negotiating or establishing any terms of the loan;

* Preparing or processing any loan documents; or

* Closing the transaction.

Disposition of Debt Instruments. The statute treats the removal or substitution of a Fasit asset by the Owner as a prohibited transaction if a primary purpose was to realize profit on the removed asset. The proposed regulations create an unnecessarily restrictive per se rule that an exchange with or distribution to the Owner of a debt instrument is a prohibited transaction if the Owner recognizes a gain on the removed debt instrument within 180 days of receiving it.

Fasit Cessation

If a Fasit terminates without IRS consent the consequences are severe. Absent relief in the case of an inadvertent cessation, if an arrangement ceases to be a Fasit its assets are marked to market on an asset by asset basis. Gains are subject to a 100% tax while losses are disallowed. If debt is satisfied at a price different from its adjusted issue price, cancellation of debt income results with no deduction for premium permitted. The regular interest holders will be deemed to have exchanged their Fasit regular interests for interests in the underlying arrangement and may be required to recognize gain (but not loss) on the exchange.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.