The recent downturn in the energy and mining sector has impacted the CLO market globally, where we are now seeing increased levels of defaulted assets in CLO portfolios.
In the US, there has been a significant uptick in the formation of 'tax blocker' subsidiaries for existing US CLO issuers with exposure to such assets. These entities, established as blocker vehicles, can hold equity or other work-out assets issued in connection with the restructure of distressed assets. This mitigates any tax risk that the associated CLO will be engaged in a US trade or business.
The issuer in a US CLO transaction is typically established outside of the US, principally to avoid being liable to pay US federal income tax on its global income. When a portfolio asset is exchanged for equity or other assets in connection with bankruptcy or workout proceedings, this may nonetheless cause the CLO issuer to be deemed to be engaged in a trade or business in the US which would subject the entire CLO portfolio to US federal tax. In order to avoid such a scenario, CLO indentures typically provide for the formation of tax subsidiaries to hold such equity. This avoids the need to dispose of such assets at a time when their value is rock bottom and gives the CLO the benefit of any work-out upside.
The formation of Delaware limited liability companies ("LLCs") as subsidiary 'tax blocker' vehicles of CLO issuers is typically the most common and cost effective solution although Delaware corporations are also sometimes used. Maples Fiduciary in Delaware provides both LLC and corporate formation services alongside complementary and related services, such as the provision of independent governance services (directors and member managers) to such LLCs and corporates.
Upon formation, the relevant defaulted assets can be transferred by or on behalf of the CLO issuer to the subsidiary LLC or corporate. However, US tax structuring requirements, including the jurisdiction of choice for the tax subsidiary, will be dictated by matters such as the nature of the defaulted asset or activity in question. In addition, provisions in the CLO indenture typically restrict the formation of subsidiaries unless specified conditions precedent are met and prescribed steps are followed. For example, prior written notice must be provided to rating agencies and legal opinions obtained to the effect that formation of the subsidiary will not cause the issuer: (i) to be deemed to be engaged in a US trade or business for US federal income taxation purposes; or (ii) to constitute a "covered fund" under the US Volcker Rule.