Collateralized Loan Obligations (Portfolio 6585)

Tax Management Portfolio, Collateralized Loan Obligations, No. 6585, describes the taxation of collateralized loan obligation issuers (CLOs) and their investors. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Tax Management Portfolio, Collateralized Loan Obligations, No. 6585, describes the taxation of collateralized loan obligation issuers (CLOs) and their investors. This Portfolio is intended to be a comprehensive reference guide for a tax advisor representing an underwriter, a collateral manager, or a prospective investor in a CLO notes issuance. We begin with a broad overview of how CLOs work, how they are structured, and the transaction documents that are relevant to a tax advisor. We then discuss in detail the different ways that CLOs can be structured for tax purposes, the tax characterization (as debt or equity) of the different classes of notes issued by a CLO, the tax consequences to investors of investing in CLO notes (which differ depending on how the CLO is structured), the tax guidelines that many CLOs follow to avoid being engaged in a U.S. trade or business for U.S. tax purposes, the consequences to a CLO of being engaged in a U.S. trade or business, how CLOs avoid U.S. withholding tax, and various other considerations relevant to CLOs, collateral managers, and investors.


Jason Schwartz

Jason Schwartz is a partner at Cadwalader, Wickersham & Taft LLP. Jason's practice focuses on tax issues relating to collateralized loan obligations and other securitizations, hedge funds and private equity funds, structured notes and other derivatives, lending transactions and other financings, and corporate acquisitions. Jason has been recognized as a Next Generation Lawyer by The Legal 500 U.S. for financial products taxation.

Jason received his B.A., cum laude , from New York University, his J.D., magna cum laude, from American University Washington College of Law, where he was inducted into the Order of the Coif, and his LL.M. in Taxation from New York University.

David S. Miller

David S. Miller is a partner at Proskauer Rose LLP. David advises clients on a broad range of domestic and international corporate tax issues. His practice covers the taxation of financial instruments and derivatives, cross-border lending transactions and other financings, international and domestic mergers and acquisitions, multinational corporate groups and partnerships, private equity and hedge funds, bankruptcy and workouts, high-net-worth individuals and families, and public charities and private foundations.

David teaches tax policy at the New York University School of Law. He previously taught the taxation of financial instruments at Columbia Law School. David is the former chair of the tax section of the New York State Bar Association.

Table of Contents

Detailed Analysis
I. Introduction
A. What Is a CLO?
1. In General
2. The Parties and Their Counsel
3. Payment Waterfall
a. In General
b. Administrative Expenses
c. Senior Management Fee
d. Secured Notes
e. Subordinated Management Fee
f. Subordinated Notes and Incentive Management Fee
4. Collateral Obligations and Eligible Investments
5. Structural Features
a. In General
b. Concentration Limitations
c. Collateral Quality Tests
d. Checks on the Collateral Manager
6. Lifecycle
a. Warehouse
b. Securitization
(1) In General
(2) Ramp-Up Period
(3) Reinvestment Period
(4) Amortization Period
7. Comparison to Other Investment Vehicles
a. Hedge Funds and Private Equity Funds
c. Mortgage REITs
B. U.S. Tax Structure
1. Elimination of Entity-Level Tax
2. Choice of Entity
a. In General
b. Advantages of Partnership CLO
(1) Net Losses Flow Through
(2) Operating Without Tax Guidelines
(3) Avoid Controlled Foreign Corporation Rules
(4) Reduce the Risk That the Incentive Management Fee Is ‘Nonqualified Deferred Compensation’
c. Advantages of a Corporate CLO
(1) Avoid Limitations on Expense Deductions
(2) Reduce Minimum Denominations for Subordinated Notes
(3) Avoid Unrelated Business Taxable Income
(4) Reduce Trade or Business Risk for Foreign Investors
d. The Best of Both Worlds: Partnership and Income Note Issuer
C. Transaction Documents
1. Offering Circular
2. Organizational Documents
a. In General
b. Pass-Through Entities
(1) Form 8832
(2) Partnership Agreement
3. Warehouse Credit Agreement
a. In General
b. Trade or Business
c. Debt or Equity
d. Tax Gross-Up
4. Collateral Management Agreement
5. Indenture
6. Income Note Paying Agency Agreement
7. Forms of Notes
8. Subscription Agreements
II. Treatment of Secured Noteholders
A. The ‘Debt for Tax’ Opinion
1. In General
2. What Constitutes Indebtedness?
3. Common Opinion Criteria
4. Section 385 Regulations
B. Withholding Tax on the Secured Notes
1. Cayman Islands Withholding
2. Irish, Luxembourg, and Dutch Withholding
3. U.S. Withholding
a. In General
b. Foreign-Source Interest
c. U.S.-Source Interest
(1) FDAP Withholding
(2) FATCA Withholding
C. Taxation of U.S. Holders
1. In General
2. Qualified Stated Interest
3. Original Issue Discount
a. In General
b. OID on Senior Notes
(1) In General
(2) De Minimis OID
c. OID on Mezzanine Notes
d. The “PAC” Method
e. Interest Rate Step-Ups
4. Dispositions
5. Foreign Currency Denominated Secured Notes
a. In General
b. Interest
c. Principal
d. Dispositions
e. Receipt of Foreign Currency
D. Change in a CLO's Entity Classification
1. In General
2. Significant Modification
3. Consequences of a Significant Modification
E. Co-Issued Notes
1. In General
2. Tax Treatment of Co-Issuer and Co-Issued Notes
3. Application of §6038A to Disregarded Entity Co-Issuers
III. Treatment of Subordinated Notes as Equity
IV. Treatment of Subordinated Noteholders in a Corporate CLO
A. Passive Foreign Investment Company
1. In General
2. Excess Distributions
a. In General
b. Gifts and Other Tax-Free Transfers
c. Death of Subordinated Noteholder
d. Distributions on Foreign Currency Denominated Notes
3. QEF Election
a. Making the Election
b. Tax Consequences of Making a Timely QEF Election
(1) QEF Inclusions
(2) Distributions
(3) Dispositions
c. Untimely Elections
(1) Unpedigreed QEFs
(2) Purging the PFIC Taint
d. Election to Defer Payment of Tax
4. CLOs Whose Functional Currency Is Not the U.S. Dollar
a. Determining Functional Currency
b. QEF Inclusions and Foreign Currency Exchange Gain or Loss
5. Indirectly Held PFICs
B. Controlled Foreign Corporation
1. In General
2. Subordinated Notes as Voting Stock
3. Subpart F Income Inclusions
4. Distributions
5. Dispositions
6. Coordination with PFIC Rules
7. Indirectly Held CFCs
8. CLOs Whose Functional Currency Is Not the U.S. Dollar
C. Foreign Currency Denominated Subordinated Notes
D. Multiple Classes of Equity
V. Treatment of Subordinated Noteholders in a Partnership CLO
A. Avoiding Publicly Traded Partnership Treatment
1. In General
2. 100-Partner Private Placement Safe Harbor
a. In General
b. Avoiding an Established Securities Market
c. Avoiding ‘Readily Tradable’ Status
d. Alternative to Minimum Denominations
e. Special Transactions that Give Rise to Publicly Traded Partnership Concerns
3. “Qualifying Income”
a. In General
b. Income Derived in the Conduct of a Financial Business
B. Allocations to Subordinated Noteholders
1. In General
2. Schedule K-1
a. In General
b. Subordinated Notes Held Through Depository Institutions
3. Allocations Between Transferor and Transferee
C. Inside Basis Adjustments
1. In General
2. Section 754 Election
3. Mandatory Adjustments
D. Limitations on Deduction
1. In General
2. Losses in Excess of Adjusted Basis
3. At-Risk Rules
4. Miscellaneous Itemized Deductions
5. Investment Interest Deductions
6. Deduction Limitations for CLOs that Are Engaged in a Trade or Business
a. In General
b. Excess Business Losses
c. Business Interest Deductions
E. Partnership Representative
F. Partnership-Level Audit Adjustments
VI. Partnership CLOs with Income Note Issuers
A. In General
B. Special Tax Concerns
1. Publicly Traded Partnership
2. Subordinated Note Conversion
a. In General
b. Consequences to Converting U.S. Noteholders and the CLO
c. Consequences to Income Note Issuer
3. Income Note Conversion
VII. Disregarded Entity CLOs
VIII. Reporting Requirements for U.S. Noteholders
Introductory Material
A. Requirements for U.S. Holders of Subordinated Notes or Income Notes
1. Corporate CLOs; Income Note Issuers
2. Foreign Partnership CLOs
B. Requirements for All U.S. Holders
IX. Consequences If Secured Notes Are Treated as Equity
A. Corporate CLOs
B. Partnership CLOs
1. U.S. Secured Noteholders
2. Foreign Secured Noteholders
X. Trade or Business Considerations
A. In General
B. The ‘U.S. Trade or Business’ Opinion
C. CLO as Mere Investor
1. In General
2. Attribution Collateral Manager's Activities
3. Frequency, Continuity, and Regularity of Activities
4. Lending as a Trade or Business
D. Securities Trading Safe Harbor
1. In General
2. Protected Activities
a. Secondary Market Trading
b. Interest Rate and Currency Swaps
c. Purchase of Publicly Offered Bonds at Initial Issuance
d. Purchase of Private Debt Securities at Initial Issuance
3. Avoiding Dealer Status
4. Loan Origination as a U.S. Trade or Business
a. In General
b. Statutory Language
c. Lending as ‘Per Se’ Dealer Activity
d. Protection from Foreign Competition
e. Loan Origination as a Service
5. Tax Guidelines Relating to Bank Loans
a. In General
b. Loan Syndication
c. No Negotiation
d. No ‘Club Deals’
e. Waiting Period After Origination
f. Commitments
g. Revolvers and Delayed Drawdown Obligations
h. Loan Modifications
i. Affiliate-Originated Loans
j. Letters of Credit
E. Alternative Safe Harbor
F. Acting from Outside of the United States
G. Ownership of Certain Equity Interests
1. In General
2. Partnerships
3. U.S. Real Property Interests
H. Consequences to a CLO of Being Engaged in a U.S. Trade or Business
1. Corporate CLOs
2. Partnership CLOs
3. Effectively Connected Income
a. In General
b. Dealer Income
c. Asset Use and Business Activities Tests
(1) In General
(2) ECI from Foreign Sources
d. ECI from a Banking, Financing, or Similar Business
(1) In General
(2) ‘Active Conduct of a Banking, Financing, or Similar Business’
(3) ‘Loans to the Public’
(4) ‘U.S. Office’
(5) Stocks and Securities ‘Attributable to’ a U.S. Office
(6) Amount of ECI Inclusion
I. Blocker Subsidiaries
1. In General
2. Foreign Blocker Subsidiaries
3. U.S. Blocker Subsidiaries
4. Limitations on Use
XI. Withholding Tax on Collateral Obligations and Eligible Investments
A. In General
B. Portfolio Interest
C. Eligible Investments
D. Fee Income
1. In General
2. Commitment Fees
3. Amendment Fees
E. Conduit Financing
F. FATCA Withholding
1. In General
2. Expanded Affiliated Groups
XII. Section 457A and the Incentive Management Fee
XIII. Special Transactions and Features
A. Refinancings
1. In General
2. Tax Consequences to ‘Rollover’ U.S. Holders
a. In General
b. Significant Modification
c. Recapitalization
3. Make-Whole Payments
a. In General
b. CPDI Rules
c. Rollover U.S. Holders
B. Additional Issuances
C. Management Fee Rebates
D. Loan Classes
1. In General
2. Conversion to Notes
3. Delayed Drawdown Loans
a. Debt for Tax Opinion
b. Commitment Fees
E. Contributions
1. In General
2. Tax Considerations

Working Papers

Table of Worksheets
Worksheet 1 Sample Tax Disclosure for Corporate CLO Organized in the Cayman Islands
Worksheet 2 Sample Tax Disclosure for Corporate CLO Organized in Europe
Worksheet 3 Sample Tax Disclosure for Partnership CLO and Income Note Issuer Organized in the Cayman Islands
Worksheet 4 Sample Tax Guidelines for U.S. Managers (Annotated)
Worksheet 5 Sample Tax Guidelines for Non-U.S. Managers
Worksheet 6 Sample “Hybrid” Tax Guidelines for Managers with U.S. and Non-U.S. Operations
Worksheet 7 Sample Transfer Restrictions for Corporate CLO
Worksheet 8 Sample Transfer Restrictions for Partnership CLO with Income Note Issuer