Collateralized Debt Obligations (CDOs) can offer attractive returns, but they’re also subject to complex accounting, tax, and regulatory requirements. As an investor, here are some things you should consider.
A CDO is a financial tool used to re-package loans into a product sold to investors in the secondary market — often organized as a foreign corporation — that holds a pool of collateralized debt. A CDO is often set up as a Special Purpose Vehicle (SPV). Depending on the nature of the underlying debt, CDOs may also be known as Collateralized Mortgage Obligations (CMOs) or Collateralized Loan Obligations (CLOs).
Interests in CDOs are typically subdivided into tranches that represent different levels of risk and reward. Most of these tranches are characterized as debt of varying seniority, although the lowest tranches, which are the first to absorb losses, are generally characterized as equity. The tax issues you need to consider as an investor depend on whether you invest in debt or equity.
Investing in Debt Securities
Investors in a CDO’s debt securities should consider the tax implications of discounts and premiums. For example, a debt instrument with an issue price that’s less than its maturity value generally has original issue discount (OID). OID is treated as interest income, with a portion included in the investor’s income each year over the life of the instrument. This is true regardless of the timing of actual interest payments, so an investor in a deferrable interest class may owe taxes on income that hasn’t been received.
Market discounts also have significant tax implications. A market discount may occur when an investor acquires a debt instrument on the secondary market for a price that’s less than its maturity value. The investor’s gain on the sale of the instrument is treated as ordinary income, rather than capital gain, to the extent of any market discount accrued before the sale date. Alternatively, an investor may elect to include market discount in income as it accrues.
In some cases, an investor might acquire a debt instrument at a premium. The investor may elect to amortize the premium and use it to offset taxable interest income. However, that premium amortization reduces the investor’s tax basis in the instrument, which may trigger additional capital gains taxes when it’s sold.
Foreign Corporation Equity
Equity investors in CDOs organized as foreign corporations must consider rules related to:
- Controlled Foreign Corporations (CFCs). A foreign corporation is a CFC if more than 50% of its value or voting power is owned by “U.S. shareholders” (U.S. investors who own at least 10% of the corporation). U.S shareholders must include their pro-rata share of a CFC’s Subpart F income in their current taxable income, whether distributed or not.
- Passive Foreign Investment Companies (PFICs). A foreign corporation is a PFIC if 1) 75% or more of its gross income is passive (interest and dividends, for example), or 2) at least 50% of its assets are held for production of passive income.
Most foreign CDOs are PFICs, and all equity investors in PFICs, including less-than-10% shareholders in CFCs, are subject to an anti-deferral regime. This includes complex, and sometimes costly reporting requirements. In addition, capital gain and certain deferred interest income is taxed as ordinary income at the highest federal rate (currently, 39.6%) regardless of the investor’s actual marginal rate. Plus, they’re subject to an interest charge on the tax related to the PFIC income as if the income were received ratably over the holding period.
Investors may be able to avoid this tax treatment by making a qualified electing fund (QEF) election, under which they include their pro-rata share of the PFIC’s net income (but not losses) in their taxable income. But this election can be risky. For example, if the CDO performs poorly in later years, investors may end up paying tax on current income but never receive a matching distribution. Additionally, there could be a character mismatch over time. The ordinary portion of QEF income may be taxed at the highest rate of 39.6% but, on exit, you may have a capital loss that may not yield the same benefit.
Understand Before You Characterize
Before investing in CDOs, familiarize yourself with the potential tax implications so you can take steps to reduce your tax liability. If you need assistance in understanding how to characterize your CDOs to take advantage of the inherent returns, please contact your Untracht Early advisor.