TAXATION OF FINANCIAL ASSET SECURITIZATION INVESTMENT TRUSTS (FASITS) © January 2008 - J. Walker Johnson and Alexis A. MaclvorTAXATION OF FINANCIAL ASSET SECURITIZATION INVESTMENT TRUSTS, NOTE: THE FASIT RULES WERE REPEALED IN 2004, EFFECTIVE JANUARY 1, 2005. HOWEVER, THE RULES CONTINUE TO APPLY TO FASITS THAT EXISTED ON OCTOBER 22, 2004. A. Qualification as a FASIT 1. FASITs are trusts that facilitate the securitization of debt obligations such as credit card receivables, home equity loans, and auto loans. See Announcement 96-121, 1996-47 LLR.B, 12. Proposed regulations under sections 860H through 860L were issued in February 2000. Eligible entities FASITs are statutory, pass-through entities. Any entity (corporation, partnership, trust, or segregated pool of assets) is eligible. Section 860L(a). Election of FASIT status a Section 860L(a)(1)(A) requires that FASIT status be elected. See also, Prop. Treas. Reg. §1.860H-1(b). Section 860L(a)(3) governs the clection, which is irrevocable without IRS consent. Rules are provided for terminations and inadvertent terminations. Interest composition requirements, a. Regular interests (1) Regular interests are treated as debt instruments, with income determined under the accrual accounting method. Section 860H(0). (2) The interest must have fixed terms that specify a principal amount, state a fixed or variable interest rate, and state a maturity date of no more than 30 years. Section 860L(b)(1). (3) Regular interests include “high-yield” interests, Section 8601.(b)(1)(B). (@) A regular interest is “high-yield” if it yields more than five percentage points above the applicable AER at the time of issue.(6) Ifaholder of a high-yield interest transfers that, interest to a “disqualified holder,” the transfer is not recognized and the transferor continues to be taxed on the income attributable to the interest Section 860K(@). (©) “Disqualified holders” include any holder other than (1) domestic C corporations (other than a RIC, REIT, REMIC or cooperative) (ii) a FASIT or (ii) dealers seeking to resell the interest. (@) Ta pass-through entity holds a high-yield regular interest in an attempt to avoid the disqualified holder rule, a special tax is imposed on the entity Section 860K(@). Ownership interest ‘The ownership interest must be held by a non-exempt domestic C corporation (other than a RIC, REIT, REMIC or cooperative). Sections 860L(a)(1)(C), 860L(a)(2) and 860L(b)(2). Prop. Treas. Reg, §1.860H-M(a)(1). Asset requirements a At the close of the third month after formation and thereafter, substantially all of the FASTT’s assets must be “permitted assets.” Section 860L(a)(1)(D). Proposed regulations define “substantially all” of the FASIT’s assets as assets the total adjusted bases of which constitute 99% of the total adjusted bases of all assets held by the FASIT. Prop. Treas. Reg. §1.860H-2(a). “Permitted assets” include cash and equivalents, permitted debt instruments, foreclosure property, and hedges. Section 860L(c), (1) “Cash and cash equivalents” is defined to include: USS. dollars; other curreney; certain debt instruments; and money market shares. Prop. Treas. Reg. §1.860H-2(c). (2) “Permitted debt instruments” is defined to include: certain fixed rate debt instruments; certain variable interest rate debt instruments; REMIC regular interests; FASIT regular interests; certain inflation indexed debt instruments; certain receivables generated through revolving credit agreements; certain stripped bonds or stripped coupons; and certificates of trust representing beneficial interests in the above-listed debt instruments. Prop. Treas. Reg, §1.860H-2(b\(1).(3) “Foreclosure property” is property acquired in connection with the default or imminent default of a debt instrument held by a FASIT, Prop. Treas. Reg. § 1 860H-2(f). (4) A “permitted hedge” or guarantee contract is one that is reasonably required to offset any differences in amounts or ‘timing that any risk factor may cause between the FASIT’s receipts on assets and its payments on regular interests. Permitted hedges and guarantee contracts may include contracts issued by the holder of the ownership interest in the FASIT. Prop. Treas. Reg. §1.860H-2(4). (9) “Permitted assets” may be acquired at any time, including after the formation of the FASIT. Transfers of property to the FASIT a. When the holder of the ownership interest in a FASIT (or a related person) contributes property to the FASIT, the holder will recognize gain immediately. Section 8601(a)(1). b. [any other party transfers assets to the FASIT, the assets will be considered acquired by the holder of the ownership interest and sold by that holder to the FASIT. Section 8601¢a)(2). c. _ Tfany assets of the holder of the ownership interest are used to support (to pay or to collateralize) regular interests, those assets are treated as sold to the FASIT. Section 8601(b). 4, The IRS may issue regulations to defer this gain, Section 8601(¢). No provisions for deferral have been proposed, See Prop. Treas, Reg. §1.8601-1(4). e. The basis of any property on which gain is recognized under section 8601 is increased by the amount of the gain recognized. Section 8601(e)(2). £. Losses on assets contributed to the FASIT are not currently allowed, but may be allowed to the holder upon the disposition of the asset by the FASIT. B. Taxation of FASITs 1 2. The FASIT is not a taxable entity. Section 860H(a). The FASIT is taxed on prohibited transactions. Section 860L(e). The tax equals 100 percent of the net income from the prohibited transaction, Generally, a prohibited transaction includes income from other thanpermitted assets, other than permitted dispositions, and certain other Prohibited activities, including loan origination by the FASIT. See Prop. Treas. Reg. § 1.860L-1. C. Taxation of regular interest holders 1. Holders of regular interests are taxed as if they held a debt instrument. Section 860H(@(1). Income attributable to the regular interest is determined on the accrual basis. Section 860H(c)(3). D. Taxation of ownership interest holders 1 All of the assets, liabilities, income, deductions, credits, ete., of the FASIT are treated as being currently that of the ownership interest holder. Section 860H(b)(1). See also, Prop. Treas. Reg. §1.860H6. The income taxed to the ownership interest holder generally equals the difference between the interest the FASIT ears fiom its loan portfolio and the interest the FASIT pays to its regular interest holders. ‘The character of the income to the holder is the same as the character to the FASIT, except that tax-exempt interest is treated by the holder as ordinary income. Section 860H(b)(). Specific rules apply to holders of “high-yield” regular interests and to the holders of ownership interests. Section 8605. a, The holder cannot offset income or gain from the FASIT with any non-FASIT losses. Section 860(2). See also, Prop. Treas, Reg. §1.8605-1. b. The holder camnot ofitet any FASIT “excess income inclusion” with any non-FASIT losses. Section 860J(a). ¢. Any NOL carryover is computed by disregarding any income arising by reason of the disallowed loss. Section 860J(b). E. Cessation of FASIT Starus If an entity or arrangement revokes its election to be classified as a FASIT, or if the FASIT fails to qualify as a FASIT (and the failure is not determined to be inadvertent), the entity continues to hold the assets of the FASIT with a fair market value basis. Prop. Treas, Reg. §1.860H-4(c), Upon cessation of a FASIT, the holder of the ownership interest is treated as exchanging the assets of the FASIT for their value as determined under‘the proposed regulations. Prop, Treas. Reg. §§1.860H-4(c)(2) and 1.8601- 2, a, Gain from the exchange is treated as income from a prohibited ‘transaction, subject to the tax imposed by section 860L(e). Losses, if any, are disallowed. Upon cessation of a FASIT, the holders of regular interests are treated as exchanging their regular interests in the FASIT for interests in the underlying arrangement. Prop. Treas. Reg. §1.860H-4(c)(3). a, Gain is recognized if the owner of a regular interest receives a non- debt interest in the underlying arrangement or a “materially different” debt interest in the underlying arrangement, Anti-Abuse Rules L Section 8601 (h) gives the Secretary authority to prescribe regulations to prevent abuse of the purposes of the FASIT rules through transactions which are not primarily related to securitization of debt instruments by a FASIT. See Prop. Treas. Reg. §1.860L-2. Section 835 of the 2004 Jobs Act repealed the FASIT rules for tax years beginning on or after January 1, 2005. The rules will continue to apply to existing FAST, to the extent that regular interests in such FASITs remain outstanding in accordance with the “original terms of issuance.”