Even worse, they provide potential unnecessary complications for collateralized debt obligations CDOs. In fact, the new rules may exclude some beneficial structures by throwing into question whether reserve accounts built up from residual cash flows in synthetic deals will cause the CDO to be treated as a variable interest entity VIE.
The Sarbanes-Oxley Act is a step in the right direction, but lacks effective deterrents. The question that requires an answer is how do we competently manage structured finance activity and deter abuse? Passthrough structures pass through all of the principal and interest payments of assets to the investors. Passthrough structures are therefore generally passive tax vehicles and do not attract tax at the entity level.
Paythrough structures allow for reinvestment of cash flows, restructuring of cash flows, and purchase of additional assets.
For example, credit card receivable transactions use paythrough structures to allow reinvestment in new receivables so bonds of a longer average life can be issued. For bankruptcy and accounting purposes, the structure should be considered a sale. This is represented in the documentation as a true sale at law opinion.
The sale is also known as a conveyance. The structure should be a debt financing for tax purposes also known as a debt-for-tax structure. Tax treatment is independent of the accounting treatment and bankruptcy treatment. An originator selling assets to an SPE will want to ensure that the sale of assets does not constitute a taxable event for the originator.
The securitization should be treated as a financing for tax purposes i. This is represented in the documentation in the form of a tax opinion. The structured solution to the bankruptcy, true sale, and debt-for-tax issues varies by venue. For example, if a U. In the U. SPEs are usually organized as trusts for tax reasons under the laws of the state of Delaware or of New York.
It is a bankruptcy remote entity. The second SPE buys the assets of the first SPE as a true sale for accounting purposes and a financing for tax purposes. Other venues are more problematic, and the regulations with respect to the local equivalent of the U. For example, two entities are required for Italian securitizations. The first entity can be onshore and purchases the assets. The onshore entity cannot issue bonds, or it will attract heavy Italian taxes. The second entity is offshore and the second vehicle issues the bonds.
Synthetic securitizations do not get true sale treatment for accounting purposes, since no asset has been sold. This is true whether the vehicle is an SPE or a credit-linked note. The motive behind these structures is to reduce regulatory capital according to regulatory accounting principles.
Funding is a non-consideration or a minor consideration. These are usually balance sheet deals for bank regulatory capital relief. Partial funding is feasible with a hybrid structure. A corollary motive is to get credit risk relief. These structures are especially popular with European banks that have cheap and abundant funding relative to U. Repackaging is another legitimate use of SPEs. By definition, they are off balance sheet, bankruptcy remote entities. Furthermore, the bank is not obligated to repurchase the transferred assets.
Accounting rules are always subject to change. FASB continually reviews the conditions to be imposed on active SPE assets through equity ownership, management agreements, or other means.
The MIE issues notes that reference only the underlying collateral specific to each note unlike the structure in which the collateral for all the EMTNs is a reference pool of assets.
The noteholders do not have a claim to any other asset owned by the SPE. The derivatives may be hedges or may actually be an underlying asset, such as a credit derivative.
The SPE purchases assets. The SPE pays the asset cash flows to the bank arrangers swap desk as one leg of a swap payment. The bank arranger provides the structured coupons due to the investors under the EMTN issue. A diverse group of investors purchases EMTNs issued by an MIE: insurance company funds, independent funds, bank sponsored funds, corporations, insurance companies, commercial banks, merchant banks, investment banks, savings banks, regional banks, and US investors eligible to purchase A assets.
The note is securitized by collateral purchased by the SPE and frequently — but not always — selected by the investor. Venues can be chosen wherever an SPE structure is allowable, but as a rule, only tax friendly venues for the specific structured finance application are chosen. While choice of venue usually revolves around tax issues, other considerations can be important.
In tax terms, we want the SPE to pay zero tax on payments flowing in and flowing out. We want to avoid corporate income tax at the venue of the SPE and the bank sponsor.
There are two withholding tax issues: 1 withholding tax at the source, the venue of the incorporation of the SPE, on EMTNs issued by the SPEs; and 2 withholding tax imposed on the underlying assets purchased by the SPEs by the country in which the assets were originated. The goal is that neither interest nor dividends paid by the SPEs is subject to withholding tax, so an ideal venue does not impose this tax.
If we choose a venue such as the Cayman Islands that does not have tax treaties in place with most jurisdictions, there is no mechanism for reclaiming tax withheld if any on the underlying asset income from the country of origination. If instead we choose a venue with tax treaties in place, assets that suffer withholding tax may specifically be chosen so the withholding tax can be reclaimed.
This is a legitimate use of an SPE. Tax evasion is illegal; tax avoidance is legal. In Europe, we also want to avoid value added tax VAT and stamp duties. The goal is to have zero tax leakage, if possible. Its legal status as a separate company makes its obligations secure even if the parent company goes bankrupt. For this reason, a special purpose vehicle is sometimes called a bankruptcy-remote entity. If accounting loopholes are exploited, these vehicles can become a financially devastating way to hide company debt, as seen in in the Enron scandal.
A parent company creates an SPV to isolate or securitize assets in a separate company that is often kept off the balance sheet. It may be created in order to undertake a risky project while protecting the parent company from the most severe risks of its failure. In other cases, the SPV may be created solely to securitize debt so that investors can be assured of repayment. In any case, the operations of the SPV are limited to the acquisition and financing of specific assets, and the separate company structure serves as a method of isolating the risks of these activities.
An SPV may serve as a counterparty for swaps and other credit-sensitive derivative instruments. A company may form the SPV as a limited partnership, a trust, a corporation, or a limited liability corporation , among other options.
It may be designed for independent ownership, management, and funding. In any case, SPVs help companies securitize assets, create joint ventures , isolate corporate assets, or perform other financial transactions.
The financials of an SPV may not appear on the parent company's balance sheet as equity or debt. Instead, its assets, liabilities, and equity will be recorded only on its own balance sheet.
An investor should always check the financials of any SPV before investing in a company. Remember Enron! Investors need to analyze the balance sheet of the parent company and the SPV before deciding whether to invest in a business. The massive financial collapse in of Enron Corp. Enron's stock was rising rapidly, and the company transferred much of the stock to a special purpose vehicle, taking cash or a note in return.
To reduce risk, Enron guaranteed the special purpose vehicle's value. When Enron's stock price dropped, the values of the special purpose vehicles followed, and the guarantees were forced into play. Its misuse of SPVs was by no means the only accounting trick perpetrated by Enron, but it may have been the greatest contributor to its abrupt fall. Enron could not pay the huge sums it owed creditors and investors, and financial collapse followed quickly.
Before the end, the company disclosed its financial information on balance sheets for the company and the special purpose vehicles. Its conflicts of interest were there for all to see. However, few investors delved deep enough into the financials to grasp the gravity of the situation. A special purpose vehicle SPV is a subsidiary company that is formed to undertake a specific business purpose or activity.
SPVs are commonly utilized in certain structured finance applications, such as asset securitization, joint ventures, property deals, or to isolate parent company assets, operations, or risks.
While there are many legitimate uses for establishing SPVs, they have also played a role in several financial and accounting scandals. Special purpose vehicles have their own obligations, assets, and liabilities outside the parent company. SPVs can, for example, issue bonds to raise additional capital at more favorable borrowing rates than the parent could.
They also create a benefit by achieving off-balance sheet treatment for tax and financial reporting purposes for a parent company. The SPV itself acts as an affiliate of a parent corporation, which sells assets off of its own balance sheet to the SPV. The SPV becomes an indirect source of financing for the original corporation by attracting independent equity investors to help purchase debt obligations.
To get the most out of the website we recommend enabling JavaScript in your browser. SPEs often have little or no physical presence, such as an office or full-time employees. They are also often part of complex chains of companies across a number of different countries. Many SPEs are seen as part of shadow banking, or non-bank financial intermediation as it is now more commonly referred to internationally.
Shadow banking is a term used to describe bank-like activities mainly lending or activities that support lending that take place outside the traditional banking sector.
To find out more about shadow banking see our explainer: What is shadow banking?
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