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Progress on US covered bond law

Thomas A HumphreysRemmelt A Reigersman
Late last year, House Ways and Means Committee chairman David Camp sent a letter to the House Committee on Financial Services (HFSC) outlining amendments to the Covered Bond Act (CBA) that significantly alter the tax treatment of covered bond pools segregated from the issuer's estate after an event of default.

Covered bonds are debt obligations that are recourse either to the issuing entity or to an affiliated group to which the issuing entity belongs, or both. Upon an issuer default, covered bond holders also have recourse to a pool of collateral (known as the cover pool), separate from the issuer's other assets.

The US does not have any legislation addressing the treatment of covered bonds. Therefore, market participants in the US have developed a synthetic two-tier structure designed to replicate the protections to covered bond holders afforded by legislation in certain European countries. The CBA, now under consideration by Congress, seeks to codify the treatment of covered bonds and provide a statutory framework for their issuance.

Under the CBA, an issuer's default results in the issuer's estate being split into two estates with the cover pool being set aside for the benefit of the covered bond holders. This framework would provide certainty to investors as to their rights to payment, and timing of such payments, if the issuer becomes insolvent or is in danger of becoming insolvent.

As originally presented to the HFSC, the CBA provides that the separate estate containing the cover pool is treated as a disregarded entity for tax purposes. Furthermore, the transfer of the cover pool from the issuer to the segregated estate is not treated as a taxable exchange. The proposed amendments to the CBA generally preserve these provisions. Under the amendments, certain transfers of the cover pool continue to be exempt from taxable exchange treatment. The segregated estate is, however, treated as a disregarded entity for tax purposes only if the residual interest in the segregated estate is held by only one person, such person is subject to income tax, and such person is not a regulated investment company or a real estate investment trust. Failing these requirements results in the segregated estate being treated as a corporation for tax purposes, subject to corporate level tax on income.

The most significant change to the CBA is the introduction of an excise tax on issuers who default on the covered bonds without subsequently filing for bankruptcy. Such issuers are subject to a tax of one percent of the principal amount of the bonds secured by the cover pool. The tax liability is extinguished (or refunded, if already paid) if the issuer enters conservatorship, receivership, liquidation, or bankruptcy during the five-year period following the creation of the segregated estate.

Camp and his staff are working with the Joint Committee on Taxation to modify the CBA so that it will have minimal or no revenue effect. Therefore, further changes to the CBA may be forthcoming. Camp's letter is a possible indication that the House Committee on Ways and Means is nearing the end of its deliberations and will soon present the bill to the full House for a vote.

Thomas A Humphreys, Remmelt A Reigersman and David J Goett

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