Dechert Develops REMIC Structure for Longer Investment Periods (“Pancake REMIC')

Mortgage securitizations must navigate a number of U.S. income tax issues to optimize financing efficiency. Key issues include avoiding entity-level taxation of the issuer, which involves addressing the taxable mortgage pool ("TMP") and publicly traded partnership ("PTP") rules. If a non-U.S. investor will hold securities issued in the securitization, consideration must be given to the U.S. withholding tax provisions and the applicability of an exemption through the portfolio interest exemption or qualification for a reduction or exemption under an income tax treaty with the United States. In addition, if a non-U.S. investor will hold an equity interest issued in the securitization, consideration must be given to the question of whether the non-U.S. investor will be treated as engaged in a trade or business within the United States and subject to U.S. income tax as a result of holding that equity interest.

Traditionally, those tax concerns have been managed by employing one of two tax structures: a Real Estate Mortgage Investment Conduit ("REMIC") or a securitization sponsored by a Real Estate Investment Trust ("REIT") through a Qualified REIT Subsidiary ("QRS"). Evolving business needs continue to drive further development and refinement of these structures.

We recently developed the first-of-its-kind REMIC structure, which involves making successive REMIC elections over time to accommodate the desire for longer investment periods. We developed the structure for a sponsor that was looking to issue time-tranched securities backed by residential transitional loans ("RTLs") outside of a REIT structure. The issuance of time-tranched securities allows for a more efficient structure from a ratings and financing perspective. Our REMIC structure for the resulting transaction has since become the dominant tax structure for the securitization of RTLs. There is no tax reason this structure could not be used for other mortgage products.

The Pancake REMIC Structure

In the past, mortgage securitizations structured as REMICs have used prefunding or reinvestment periods of no more than three months. This reflected the prefunding period provided for in the Internal Revenue Code (the "Code"), which limits the prefunding period of any one REMIC to three months.¹ To address this limitation, we developed (and have implemented in several transactions) a structure that uses a series of cascading REMIC elections, made over time, to join together REMICs that will accommodate longer prefunding and reinvestment periods (e.g., two years). We refer to this structure as the "Pancake REMIC."

The Pancake REMIC structure begins with the traditional two-tiered REMIC structure, having an upper-tier REMIC and a lower tier REMIC. The upper-tier REMIC holds as its assets all the regular interests issued by the lower-tier REMIC and issues its regular interests (in the form of certificates or notes) to investors. The lower-tier REMIC holds any initial mortgage assets and any prefunding amount. During its three-month prefunding period, the lower-tier REMIC can purchase mortgage assets using the prefunding amount or payments received on its mortgage assets. Until the end of that period, this aligns with the path of all previous REMIC transactions with prefunding. The twist comes at the end of the three-month startup period. At that time, the upper-tier REMIC transfers the lower-tier regular interests it holds to a newly formed REMIC in exchange for the regular interests issued by the new REMIC, resulting in a tiered REMIC structure with the lower-tier REMIC being on the bottom, the new REMIC being in the middle, and the upper-tier REMIC being on top. The new REMIC (that is, the middle-tier REMIC) will then begin its three-month prefunding period. Any prefunding amount remaining in the lower-tier REMIC can be distributed to the middle-tier REMIC along with any other distributions of payments received on mortgage assets held by the lower-tier REMIC. All such amounts will be available to the middle-tier REMIC to acquire new mortgage assets during its three-month prefunding period. Successive REMICs can be formed in a similar manner. Throughout this process, the investors continue to hold their original regular interests (that is, the original certificates or notes issued by the upper-tier REMIC) and will have no tax consequences as a result of the subsequent REMIC elections.

The ability of one REMIC to transfer the regular interest it holds for the regular interests in a newly formed REMIC is provided by Section 860G(a)(4)(B)(i), addressing "qualified replacement mortgages." That section provides that the term "qualified replacement mortgage" includes an obligation that would be a qualified mortgage if transferred on the startup day and that is exchanged for another obligation within the first three months following the REMIC's startup day.² Note that, in contrast to the rule provided in Section 860G(a)(4)(B)(ii), which provides for exchanges of defective obligations within two years of the startup day, no reason is required for an exchange within the first three months.³

The foregoing clearly complies with the language of the statute. In addition, the IRS has acknowledged the separate existence of multiple REMICs formed at the same time and as part of the same transaction.⁴ Further, the IRS has acknowledged that REMICs are elective, for which no business purpose or economic substance analysis is required.⁵ Nonetheless, some may question whether the IRS might object to the Pancake REMIC structure on policy grounds. Those concerns should be addressed by the fact that the Pancake REMIC structure requires another REMIC election to extend the reinvestment period, with all the accompanying consequences (for example, another residual interest and additional tax reporting). As an alternative to the Pancake REMIC structure, the parties to a transaction could obligate themselves to form a new REMIC at the end of the first prefunding period and to have the new REMIC acquire assets during the next three months. The Pancake REMIC simply internalizes that additional REMIC election, permitting prefunding through a REMIC structure that could have been effected otherwise.

As a practical matter, implementing the Pancake REMIC structure necessarily requires compliance with mechanical REMIC rules. As with other tiered REMIC structures, the successive REMIC elections will be managed by a trustee or other administrator and should not be a concern for investors, which in our experience with several transactions has been the case. Accordingly, parties looking for longer prefunding or reinvestment periods, which may have otherwise used a QRS for such transactions, may want to consider whether the Pancake REMIC structure would work for them.

Conclusion

Since our introduction of the Pancake REMIC structure, it has since become the dominant tax structure for the securitization of RTLs. Because there is no tax reason this structure could not be used for other mortgage products, we expect that it will be. In addition, we see possible applications of the Pancake REMIC structure to address other tax issues.

Should you have any questions about the Pancake REMIC structure or the taxation of mortgage securitization transactions generally, please contact Will Cejudo or Daniel Ng.