As discussed, the cross reference to the OID rules as well as the special rules were intended to allow a taxpayer to avoid recognizing tax gain in the absence of economic gain that may result from a broad application of the special valuation rule. Despite the broadening of the definition of “traded on an established securities market: there are debt instruments that will not meet any of the above criteria that will be subject to the special valuation rule. In order for any of the scenarios contemplated above to be viable, the debt instruments utilized must avoid characterization as “traded on an established on a securities market”. While the proposed regulation have narrowed the pool of debt instruments subject to the 120 per cent special valuation rule provided for in Section 860I(d)(1), there remain instruments that would not qualify as “traded on an established securities market” under the proposed regulations that could be utilized in the contemplated scenarios.
C. Anti-abuse legislation
The proposed regulations include a broad anti-abuse rule modeled after the anti-abuse rule in the partnership regulations. Proposed Section 1.860L(a) provided that the FASIT provisions are intended to promote the spreading of credit risk on debt instruments by facilitating the securitization of those debt instruments. “Implicit in the intent of the FASIT provisions are the following requirements:”
- assets to be securitized through a FASIT consist primarily of permitted debt instruments;
- the source of principal and interest payments on a FASIT’s regular interest is primarily the principal and interest payments on permitted debt instruments held by the FASIT (as opposed to receipts on other assets or deposits of cash); and
- no FASIT provision may be used to achieve a federal tax result that cannot be achieved without the provision unless the provision clearly contemplates that result.
The regulations go on to say that if a principal purpose of forming or using a FASIT is to achieve results inconsistent with the intent of the FASIT provision and regulations, the Commissioner may make any appropriate adjustments with regard to the FASIT or any arrangement or transaction involving the FASIT. Such adjustments include, among others, disregarding the FASIT election, reallocating items of income, deduction, loss, and credit, recharacterizing regular interests, and redesignating the holder of the ownership interest.
Commentators on the FASIT provisions had urged the drafters to direct any anti-abuse at the avoidance of tax on income allocated to the ownership interest, but avoid a more general anti-abuse rule based on “carrying out Congressional intent”. The provisions above are clearly much broader and result in the casting of a wide net that could potentially result in the retroactive recharacterization of transaction that seems to be allowed if not no sanctioned by the FASIT provisions and regulations. Such a broad anti-abuse rule with no safe harbor provisions results in a situation where there is no clear guidance and taxpayers are left to contemplate the Service’s interpretation of Congressional intent. While it is likely that many of the comments received in response to the Service’s request for comments on the proposed legislation will oppose the inclusion of this broad anti-abuse rule, the remainder of this document presumes that the anti-abuse language in the proposed regulations will be retained without alteration in the final regulations.
In order to avoid (or minimize) the chances of running afoul of the anti-abuse rules the legislative history of FASIT provisions and the language of the anti-abuse rule can be used as practical guidance.
- Legislative history
The Small Business Job Protection Act of 1996 created the FASIT to facilitate the securitization of debt obligations such as credit card receivables, home equity loans and auto loans. The intent of the FASIT legislation was to achieve more diversity and liquidity in the Nation’s financial markets. According to the Join Committee’s explanation of the legislation: Congress believed that there are substantial benefits to the economy from increased securitization of assets in debt form because securitization of such assets will spread the risk of credit on the debt to others. According to the Congress, spreading this risk would lessen the concentration of such risks in banks and other financial intermediaries which in turn would lessen the pressure on Federal deposit insurance. Further, the spreading of credit risk through securitization would result in lower interest rates for consumers.
The FASIT provisions facilitate these ends by ensuring (i) the avoidance of entity-level tax on the treatment of FASIT regular interests and (ii) the treatment of regular interests as debt for tax purposes. The certainty provided is intended to eliminate economic inefficiencies that may have been caused by the uncertain tax treatment of such arrangements in the past. In return for this certainty, taxpayers must recognize taxable gain on the contribution of assets to a FASIT and face certain anti-abuse rules such as the 100 per cent tax on the holder of an ownership interest on the net income derived from prohibited transactions. As guided by the legislative history, in order to be respected, transactions must facilitate the securitization of debt obligations. Presumably, the greater securitization and spreading of credit risk achieved, the more likely it is that a transaction will be respected.