Tax, transfer pricing and securitization vehicles: what’s new?

Securitization vehicles can be a powerful vehicle for carrying out third-party debt investment, but recent structuring options have introduced transfer pricing considerations that were previously overlooked. Market participants should be mindful of transfer pricing regulations while optimizing their strategies to leverage the flexibility of these vehicles. Adhering to the arm's length principle can help manage associated risks. Proactive collaboration with tax and transfer pricing experts is crucial for ensuring compliance and achieving financial objectives.

Introduction

Transfer pricing refers to the pricing of transactions, such as loans and goods, between related entities. It plays a crucial role in ensuring that transactions between these entities are conducted at arm's length, reflecting market conditions. 

Securitization involves pooling various types of financial assets (such as loans, mortgages, or receivables) and converting them into securities that can be sold to investors (usually in the form of notes). The securitization vehicle can be structured in different legal forms (corporate, partnership and fund) and with different compartments achieving legal segregation of each asset and corresponding liability. The underlying assets of a securitization vehicle are third-party investments. In principle, securitization vehicles should not actively manage their assets, but “active management” is permitted for “debt securities, debt financial instruments, or claims,” provided that there is no offer to the public. 

Usually, Luxembourg securitization vehicles are set up as orphan. The term "orphan" refers to the fact that the vehicle is typically set up in such a way that it is not owned or controlled by the originator of the underlying assets. The securitization vehicle is often controlled by a foundation (such as a Dutch Stichting), rather than the originator. This ownership structure helps to isolate the vehicle from the originator's risks and liabilities, enhancing the bankruptcy remoteness of the vehicle.

Some securitization vehicles in Luxembourg are not set up as orphan entities but as investment vehicles of a credit fund (for example) that contributes to the funding of the underlying debt investments, either with equity, debt, or a mix of the two. This structuring allows for the same flexibility and risk isolation as an orphan securitization vehicle while enabling better control over the securitization vehicle by subscribing to its shares. 

In the context of an orphan securitization vehicle, transfer pricing considerations are very limited since there are no intragroup transactions. On the liability side, the notes will be issued to third-party investors, and on the asset side, investments are carried out with unrelated parties as well. However, when discussing non-orphan securitization vehicles, transfer pricing considerations are more relevant since the notes will be issued to a related party, and therefore, transfer pricing rules should be considered.

Specific tax and transfer pricing considerations 

The interplay of tax, transfer pricing, and securitization vehicles (non-orphan) presents unique opportunities for market players. 

When setting up a securitization vehicle, one of the first steps is to understand what the best type of funding for the given underlying investment would be. As mentioned above, the securitization vehicle could be fully equity-funded. In that case, there will be no transfer pricing considerations. 

However, in some cases, a fully equity-funded securitization structure may not be perceived as flexible as funding with a mix of debt and equity. In this case, it will be important to ensure that the payables (usually notes) issued by the securitization vehicle comply with the arm’s length principle. To do so, the securitization vehicle should realize an arm’s length remuneration to be retained and seen as the remuneration for the shareholder who injected equity into the structure. It should be noted that, in line with the qualification of the company as a securitization vehicle, the tax implications related to the arm’s length remuneration should be very limited.

The arm’s length remuneration will highly depend on the categorization (which is linked with the risk profile) of the securitization vehicle from a transfer pricing perspective. A functional analysis should be carried out to identify the functions, assets, and risks of the securitization vehicle. In addition, the main driver of the transfer pricing categorization will be the type of functions carried out by the securitization vehicle. Therefore, if the entity will carry out active management activities, more functions should be allocated to it and we would expect the arm’s length remuneration to be slightly higher than the arm’s length remuneration in the case of non-active management. This is because the functions performed by a securitization vehicle with active management should be more relevant in the context of managing the underlying investments.

Furthermore, from a tax and transfer pricing point of view, the articles of association of the securitization vehicle and the terms and conditions of the payables should be reviewed:

• Articles of Association: Typically, there is a stated intention to distribute the dividends generated by the profit of the securitization vehicle as they arise. This is necessary to reflect the business purpose of the securitization vehicle. 
• Terms and Conditions of the Payable: If the securitization vehicle carries on active management, the payable agreement should allow the reinvestment of proceeds generated from the underlying investment. In addition, the payable should have the correct risk limitation clauses in line with the transfer pricing categorization of the entity.

It is also crucial to review how the securitization vehicle is viewed from a foreign tax point of view. In this respect, leaving an arm’s length remuneration (which is a profit margin for the securitization vehicle) could be seen as fostering the market presence and status of the securitization vehicle as beneficial owner and not as a simple pass-through entity. The same applies to active management, which allows the securitization vehicle to reinvest and make active decisions on its investments.

Securitization vehicles are an efficient tool for carrying out third-party debt investment. The main reasons for this are:

• The tax implications are limited when the vehicle is set up correctly;
• There is wide flexibility in terms of underlying investments and the possibility of ring-fencing between various investments, thanks to the compartments;
• Transfer pricing implications are limited but should always be reviewed;
• Active management: The ongoing oversight and strategic decision-making involved in managing the underlying assets within a securitization structure can enhance the substance of the vehicle, particularly towards foreign countries. Nevertheless, active management should be properly documented (for example, in the notes to the annual accounts), and it requires additional functions to be carried out by the securitization vehicle, which will impact its arm’s length remuneration.

Best practices for tax and transfer pricing 

Tax Structuring and Transfer Pricing Documentation: When setting up a non-orphan securitization vehicle, the shareholder should maintain comprehensive documentation to support the best way to structure the funding of the underlying investment as well as its transfer pricing position. This documentation should include analyses of asset types, a review of the underlying country of investment (to select the most appropriate funding), and a detailed tax and transfer pricing assessment.  In addition, all necessary legal documents should be carefully drafted to include specific clauses that reflect the company's actual activities — such as active portfolio management — ensuring alignment with its functional profile and supporting its transfer pricing position.

Regular Reviews: In the case of active management, the securitization vehicle, together with its shareholder, should conduct regular reviews of their assets. This includes reassessing asset valuations, pricing arrangements, and risk allocations to ensure alignment with market conditions and regulatory requirements. Regular reviews can help identify potential issues before they escalate into more complex challenges.

Conclusion

Securitization vehicles are a staple for carrying out third-party debt investment. However, while transfer pricing was previously considered not applicable for orphaned securitization vehicles, there may be transfer pricing considerations that should be taken into account for securitization owned by funds. Market players interested in the flexibility that securitization vehicles can offer should consider the transfer pricing regulations while optimizing their securitization strategies. By adhering to the arm's length principle, they can effectively manage transfer pricing risks associated with securitization vehicles. Proactive engagement with tax and transfer pricing experts will be key to ensuring a robust structure, correct compliance, and supporting the market players’ overall financial objectives.