Near the beginning of the 1980s cult classic film “Repo Man,” Harry Dean Stanton informs Emilio Estevez that the car which he just drove back to a used-car lot was a repossessed vehicle. Upon hearing the news, Estevez empties his can of beer on the pavement and shouts, “I ain’t no repo man!” Stanton then tells him, “You are now, kid.”
Like the Estevez character in the film, many banks find it quite easy to enter the sale-repurchase (repo) business. Although standard “vanilla” repos on liquid assets are a mature, widely-used technology, the United States federal income tax treatment of this type of transaction is somewhat uncertain. This means that care must be taken when entering into repo transactions on certain types of assets, and with certain types of counterparties.
In a typical repo transaction, one party (the repo seller) sells assets to another party (the repo buyer) subject to a commitment to sell the assets back to the repo seller. While the repo is outstanding, the repo buyer makes payments (substitute dividend payments, or substitute interest payments) to the repo seller equal to actual dividends or interest paid on the asset, less a rebate. If, as may be the case in low interest rate environments, payments of current income on the asset are less than the rebate, the repo seller pays a net fee to the repo buyer.
In economic terms, a repo is a secured lending arrangement. The repo buyer buys the assets at a discount (a haircut) to fair market value to ensure over-collateralization. In the event of counterparty default, the repo buyer’s obligation to sell the assets back to the repo seller disappears, and the repo buyer can seize the assets to satisfy the repo seller’s obligation to buy them back.
For tax purposes, the treatment of a repo depends on the terms of the agreement. Most existing tax repo authorities treat repos as secured loans. Under these authorities, the repo seller is treated as the tax owner of the assets during the term of the repo, and the repo buyer is treated as holding the assets as collateral. However, there is a risk that these authorities do not apply to modern repos on liquid, fungible assets. This is because the repo buyer in the existing authorities generally did not have the right to sell or rehypothecate the assets, while the repo buyer in a modern repo often has the right to sell or rehypothecate.
Why should this matter? The answer goes to U.S. federal income tax principles regarding the determination of tax ownership. In determining who is the tax owner of an asset, courts and the IRS look beyond mere legal title to the economic substance of the transaction. In the case of illiquid assets, courts and the IRS treat the party who has economic exposure to the asset as the owner thereof. By contrast, in the case of liquid, fungible assets, the party who has control over the disposition of the asset is treated as the owner.
Under the foregoing rules, a repo of a liquid, fungible asset ought to be treated as a secured lending arrangement if the repo buyer’s right to sell or rehypothecate the asset is limited. In this case, the repo seller would be treated as the tax owner of the asset. By contrast, there is a substantial possibility that a repo buyer of liquid, fungible property who has the right to sell or rehypothecate the property could be treated as the owner thereof – and the repo treated as a true sale and repurchase.
The standard Master Repurchase Agreement (MRA) issued by the Bond Market Association allows the repo buyer to sell or rehypothecate assets purchased under a repo. In many cases, the resulting legal uncertainty should merely be of academic interest. However, the repo buyer’s right to rehypothecate should be restricted in the following three cases:
- Munis – U.S. Taxable Repo Seller: If municipal bonds are "repoed out" by a taxable U.S. repo seller, the repo seller will want the repo buyer’s right to sell or rehypothecate to be limited. This is because, if the repo is respected as a collateralized loan, the repo seller will be treated as the tax owner of the munis. If this is the case, substitute interest payments should be treated as tax exempt muni interest. By contrast, if the repo is not treated as a collateralized loan, the repo buyer will be treated as the owner of the munis, and substitute interest payments made to the repo buyer should not be tax-exempt.
- MLPs – Offshore Repo Buyer: If interests in U.S. Master Limited Partnerships (MLPs) are purchased by an offshore repo buyer that is not engaged in a U.S. trade or business, the repo buyer will want its right to sell or rehypothecate to be limited. U.S. nonresidents who own interests in partnerships that are engaged in a U.S. trade or business are deemed to be engaged in the partnership’s U.S. trade or business by virtue of their ownership of these interests. MLPs constitute “partnerships” for these purposes. Therefore, an offshore repo buyer who is not otherwise engaged in a U.S. trade or business who holds MLP interests pursuant to a repo will want to ensure that the repo seller, rather than the repo buyer, is treated as the owner of the repossessed assets. The best way to do this is to restrict the repo buyer’s ability to sell or rehypothecate the MLP interests.
- REMIC Interests – REIT Repo Seller: It is common for mortgage REITs to finance purchases of mortgage certificates and REMIC interests on repo. In cases of this type, the repo seller will want the repo buyer’s right to sell or rehypothecate to be limited. In order to qualify as a REIT, an entity must, inter alia, have a minimum amount of “good” real estate assets on its balance sheet. REMIC interests and mortgage pass-through certificates generally constitute “good” assets for these purposes. Therefore, if a REIT sells a REMIC interest or a mortgage pass-through certificate on repo, the REIT will want to ensure that the repo is respected as a collateralized loan.
More information is available upon request.