CLOs Get Some Relief Under Final Rules

Collateralized loan obligations issued before 2012 may get a reprieve from onerous new regulations meant to battle international tax evasion, though the Loan Syndications and Trading Association is still assessing how much of the market is still vulnerable to steep monetary penalties for non-compliance, sister service Thomson Reuters Loan Pricing Corp. reported.

In final Foreign Account Tax Compliance Act rules published on Jan. 17, the U.S. Treasury and IRS gave some leeway when it comes to existing CLOs that are constrained from becoming compliant. Under the law requiring foreign financial institutions to report to the IRS accounts with offshore assets over $50,000, loans that are issued, or amended with a spread of at least 25 basis points, after the new extended deadlines could be subject to a 30 percent withholding tax.

The grandfathering deadline was pushed out to January 1, 2014, and loans issued or amended prior to that date won’t be subject to FATCA rules. Standby letters of credit and revolver deals signed by the deadline will also be grandfathered obligations even if draw-downs occur after January 1, 2014.

One concern had been that if a grandfathered revolver was drawn after that date, the IRS would consider it a new loan, eliminating the grandfathering protection. In a new development, the IRS created a “Deemed Compliant” category for limited-life debt investment entities such as CLOs. If qualifying, an entity would not have to sign an FFI agreement with the IRS or comply with due diligence requirements envisioned by FATCA.

“What they’ve done is added a new category that we believe pre-2012 CLOS may be able to take advantage of,” Tess Virmani, assistant LSTA general counsel, said in an interview. The group is assessing whether any pre-2012 CLOs may not benefit.

“If the CLO exists as of Dec. 31, 2011, and such pre-2012 CLO satisfies a number of requirements, you may have a temporary exemption until the end of 2016,” Virmani said. “Our understanding is that for post-2011 CLOs, because FATCA has been part of the conversation, provisions have been made in organizational documents so they are not in the same position as the pre-FATCA CLOs.”

Withholding penalties would be on interest payments, principal payments and sales proceeds on non-grandfathered loans.

“That’s very material money for non-compliant FFIs in, say, a $1 billion loan,” said Meredith Coffey, LSTA executive vice president of research and analysis. “The situation is better, but it’s far from resolved.”

That’s partly because the Deemed Compliant category is transitional, with protection only through 2016. After that, CLOs will either have to be compliant with FATCA or with whatever obligations are contained in intergovernmental agreements. The United States entered some of these agreements with countries where local privacy and data protection laws kept institutions from complying with FATCA. Dozens more agreements are near finalization, the U.S. Treasury Department has said.

“If there is no intergovernmental agreement, the CLO could be in the same position starting in 2017 of having to comply with FATCA but not being able to,” Virmani said. Beginning Jan. 1, 2017, sale proceeds and principal repayments would be subject to a 30 percent withholding if that CLO were not compliant. “The expectation is that a very significant amount of the pre-2012 CLOs will probably be called prior to that 2017 date, but we can’t guarantee that,” said Coffey.

Another lingering concern is the threshold for material loan modifications. A loan is grandfathered if entered into before Jan. 1, 2014, but a material modification can wipe out the grandfathering status.

“The threshold for material modification is quite low in the loan market where amendments are so routine,” said Virmani. “Basically, any amendment that extends the maturity or an amendment with a 25bp spread change would be a material modification. The potential to lose grandfathering status is very real in the loan market.”

While continuing to assess the overall impact, LSTA expects the final rules and official deadline extensions to lend some certainty to the CLO market. CLO issuance, which leaped to about $55 billion in 2012 from $13 billion in 2011, could reach about $75 billion this year, according to a Thomson Reuters LPC survey.

Lynn Adler is a reporter for Thomson Reuters LPC.