Withholding Taxes and CLO Eligibility Criteria: An Overview of European Withholding Tax Risks for U.S. CLOs and Potential Solutions

In light of the recent article published by 9fin regarding the adverse implications to U.S. collateralized loan obligations (“CLOs”) that resulted from U.K. withholding taxes imposed with respect to a certain dividend financing loan issued by the CFC Group, we thought the time was ripe to provide a more extensive overview of the issue and introduce potential strategies to address the risk, including the use of fiscally transparent issuers, permitted withholding tax asset buckets and Luxembourg subsidiaries.

The successful implementation of these strategies will require not only careful planning and legal expertise but also deep experience in cross-disciplinary, multi-jurisdictional transactions and in negotiating across from, and navigating through the intricacies with, investors, arranger banks and rating agencies.

Key Takeaways

• Withholding taxes can have adverse effects on CLOs, including an obligation to sell or dispose of the asset and exclusion of such asset from various coverage tests under the indenture.
• CLOs in the market (in particular, BSL CLOs) are not structured to avoid European withholding taxes.
• Some CLOs (in particular, MM CLOs formed as limited partnerships) may already have in place appropriate structures to avoid European withholding taxes due to their status as fiscal transparent entities under income tax treaties.
• Permitted withholding tax asset buckets may present the most viable solution for managers that do not expect to deploy considerable capital in European assets but desire to protect their CLOs from inadvertent acquisitions.
• Luxembourg subsidiaries may present a viable solution for some CLOs (in particular, those with considerable amounts of European assets), although the implementation of the strategy entails material costs and careful international tax planning.

Overview of CLO Eligibility Criteria and Withholding Taxes

CLOs are subject to strict requirements under the indenture as to the types of assets they can acquire. With certain narrow exceptions, for an asset to be eligible for purchase by a CLO, it must satisfy a certain set of eligibility criteria (often integrated into the definition of “Collateral Obligation”), including a criterion (the “Withholding Criterion”) that payments on the asset are not subject to withholding taxes, unless the obligor is required to make “gross-up” payments to the CLO to “make whole” for any such tax.

The Withholding Criterion is tested as of the trade date. Accordingly, if payments on an asset would give rise to withholding taxes under the law in effect as of the trade date, such asset would ordinarily fail the criterion and consequently would not constitute a Collateral Obligation. Contrary to a common misperception, gross-ups or tax indemnities in loan agreements for the assets do not ordinarily cure the defect. Most credit agreements require gross-ups or tax indemnities only with respect to withholding taxes that arise as a result of a change in law after the date of the joinder. Conversely, if payments on the asset would not give rise to withholding taxes under the law in effect as of the trade date, the asset would satisfy the Withholding Criterion and any withholding taxes arising from a change in law after the trade date would not alter that status.

Failure to satisfy the eligibility criteria could have adverse implications for the CLO, including an obligation to sell or dispose of the asset and exclusion of such asset from various coverage tests under the indenture. In addition, withholding taxes would reduce the investment return and, if substantial in magnitude, could trigger a tax redemption of the CLO Notes.

Withholding Taxes of European Jurisdictions, Income Tax Treaties and Qualifying Lenders

CLOs ordinarily do not face difficulties in claiming exemptions from U.S. withholding taxes. This applies equally to middle market loan CLOs (“MM CLOs”) and broadly syndicated loan CLOs (“BSL CLOs”). BSL CLOs ordinarily rely on the “portfolio interest exemption,” which was enacted precisely to promote foreign investments into the United States. And consistent with the legislative purpose, the qualifications for the portfolio interest exemption do not present material issues for foreign investors acquiring U.S. loans, including BSL CLOs formed in a tax-advantaged jurisdiction.  

The withholding tax laws of some European countries, however, are not as favorable. In the CLO context, withholding taxes are ordinarily imposed (e.g., on interest paid by a U.K. obligor) unless the CLO qualifies for relief under a bilateral income tax treaty. The wrinkle is that tax-advantaged jurisdictions (e.g., Cayman Islands, Jersey or Bermuda) generally do not have income tax treaties with European countries, at least not a treaty that could provide a viable solution for most CLOs (e.g., United Kingdom – Jersey income tax treaty).

Often the question of withholding taxes is raised at the time of the acquisition of the loan in connection with the assignment or subscription process. Lenders are commonly required to represent that they are, or are not, “qualifying lenders.” The definition is complex, but the general purpose of the requirement is to determine whether payments to the lender may be made free of withholding taxes by reason of an exemption provided under domestic law (e.g., portfolio interest exemption) or an income tax treaty. Where the obligor or co-obligors have connections to multiple jurisdictions, the definition would entail sub-categories. For example, where co-obligors have connections to the United Kingdom and the United States, a lender would be requested to represent that it is, or is not, a qualifying UK lender and/or a qualifying US lender. For reasons described earlier, U.S. BSL CLOs (which are primarily resident in tax-advantaged jurisdictions) will inherently have difficulties satisfying the definition of qualifying lender where the obligor has connections to the United Kingdom or another European country.   

Treaty Structures and Fiscal Transparency

There may, however, be a structural path for CLOs (including offshore CLOs) to claim treaty relief, although narrow in practice. Some CLOs (particularly MM CLOs) may already have in place the appropriate structure to claim treaty relief through the fiscal transparency route discussed below.

The general notion in the income tax treaty context is that where an entity is “fiscally transparent” (very generally, taxed in a manner akin to pass-throughs or partnerships under U.S. tax law) under the tax laws of the country of its equity holder, the entity (or the equity holder) may avail itself of the benefits of the tax treaty between the residence country of the equity holder and the residence country of the obligor (the “source country”).

The key requirements to treaty relief are that (1) the CLO is “fiscally transparent” under the tax laws of the residence country of the equity investors and (2) the equity investors are entitled to an exemption from withholding taxes under the income tax treaty between its residence country and the source country.  

The vast majority of CLO issuers are formed as Cayman Ltds or Delaware LLCs for various commercial reasons, one of which is familiarity with the jurisdiction and the local laws governing the business association. Cayman Ltds and Delaware LLCs are ordinarily understood not to be fiscally transparent under the laws of many jurisdictions. But what makes the matter more complex is that Cayman Ltds and Delaware LLCs, even if treated as pass-throughs for U.S. tax purposes (through an election or otherwise), may not be respected as fiscally transparent for these purposes by the source country taxing authority. For example, there is a level of uncertainty as to whether the U.K. taxing authority would respect a treaty claim made by a U.S. equity holder in a Cayman Ltd with respect to income generated by the Cayman Ltd that has elected to be taxed as a pass-through for U.S. tax purposes, despite the general approach to fiscal transparency in the treaty context.

Limited partnerships (e.g., Delaware or Cayman LPs) are ordinarily understood to be fiscally transparent under the laws of many jurisdictions. Some CLO issuers (in particular, a smaller pool of MM CLO issuers) are formed as limited partnerships, albeit for a different tax goal of avoiding U.S. net income taxation. The complexity in implementing this strategy lies in the fact that income tax treaties are by and large bilateral and consequently under this strategy each equity investor would need to qualify for relief (and attest to such qualification) under all income tax treaties between the investor’s residence country and the various respective countries in which the current or future portfolio obligors are resident. Given the number of potential European source countries in a CLO portfolio, the viability of the treaty strategy is most promising where the CLO has a single equity investor that is resident in a jurisdiction with a wide European treaty network (e.g., U.S. insurance companies).

The adoption of, or conversion to, a limited partnership form, however, may face difficulties in practice in light of various non-tax legal or commercial considerations that shape the choice of entity, especially in a space where standardization is heavily emphasized for promoting efficiency in deal execution and marketability of the product.   

Permitted Withholding Tax Assets

The most immediate strategy would be to add a feature in the indenture that would permit the CLO to have a portion of its portfolio consist of assets that produce payments subject to withholding taxes but otherwise constitute Collateral Obligations. This strategy makes the most sense for a CLO that does not expect to deploy considerable capital in European assets but nevertheless seeks to protect itself from inadvertent acquisitions of withholding tax assets or to reserve the optionality for special situations (e.g., where the investment is attractive or desirable even on an after-tax basis).    

Only a small number of CLOs in the market utilize this feature, which has had difficulties gaining market traction due to investor opposition that is likely grounded on the observation that the feature does not actually cure the withholding tax but merely permits CLOs to purchase otherwise ineligible, potentially lower-yielding assets.

Luxembourg Subsidiaries

A more novel strategy would be to permit CLOs to acquire withholding tax assets through a Luxembourg-based subsidiary (e.g., a Luxembourg société anonyme or société à responsabilité limitée) that would effectively permit the CLO to benefit from income tax treaties between Luxembourg and other European countries in its treaty network.

This strategy, however, does come with a material formation and maintenance cost and so the viability of this strategy may be promising only where the manager intends to fully utilize the European asset bucket for the CLO. In addition, the relevant tax laws of Luxembourg (including deductibility of interest, withholding tax and EU anti-hybrid rules) can be quite complex, and so proper international tax planning is crucial to the successful implementation of this strategy. Moreover, given the bilateral nature of tax treaties (as discussed above), tax counsel should be consulted on withholding tax laws of the source country to ensure that the source country taxing authority would respect the desired outcome.

To date, only a small number of CLO managers have installed this feature in their CLO indentures, and even for those managers, it is not entirely clear whether the feature was ever utilized (or, at least regularly utilized).

Luxembourg subsidiaries are widely used in the private funds space, particularly where the fund deploys a significant amount of its capital in European loan assets. By contrast, for various commercial reasons, CLOs today are prohibited from forming subsidiaries, other than co-issuers and tax subsidiaries that are used to prevent the CLO issuer from being treated as engaged in a U.S. trade or business. Accordingly, most CLOs today do not have the ability to form and utilize a subsidiary for purposes of reducing withholding taxes (as opposed to U.S. net income taxes), notwithstanding that reduction of withholding taxes could potentially benefit all deal constituents.

We envision that a Luxembourg subsidiary would need to be subject to materially identical restrictions (e.g., bankruptcy remote SPV and tax-related restrictions) that apply to the CLO issuer. From a tax perspective, a Luxembourg subsidiary would need to be subject to the same U.S. tax guidelines, if any, as the CLO issuer and the CLO issuer would need to obtain (at the time of the subsidiary’s formation) tax advice or an opinion of counsel to the effect that, except for any minimal corporate tax or charge payable to Luxembourg, the Luxembourg subsidiary will not be subject to Luxembourg corporate or income tax and any payment (whether in the form of interest or dividend) made by the Luxembourg subsidiary to the CLO issuer will not be subject to Luxembourg withholding taxes.