Amendments to the Corporate Income Tax Act which went into effect on 1 January 2014 provide an opportunity to revive the practice of subparticipation in lending in Poland.
Regulations governing subparticipation have been in force since 2004. For tax reasons, however, subparticipation has remained much less popular in Poland than assignment of receivables, despite certain other advantages, particularly the greater ease of selling participation in loans backed by mortgages.
In this article we will discuss the legal nature of subparticipation and how the new tax treatment may remove a fundamental barrier to the widespread use of subparticipation in Poland.
Legal structure of subparticipation
“Qualified” subparticipation is an arrangement between an initiator and a securitisation fund (or a fund management company which is to form a securitisation fund) which falls under the definition of a subparticipation agreement in Art. 183 of the Investment Funds Act:
“4. An agreement on transfer to a fund of all payments received by the initiator of the securitisation or the holder of the securitised receivables from a specific pool of receivables or from specific receivables (a subparticipation agreement) must contain an undertaking by such entities to transfer to the fund:
- the receipts from the securitised receivables in their entirety;
- the principal amounts of the securitised receivables;
- amounts obtained from enforcement of the security for the securitised receivables—if the initiator of the securitisation or the holder of the securitised receivables is satisfied through exercise of the security. …
“6. A subparticipation agreement may not contain provisions for postponement of payment or payment in instalments for the receivables which are the subject of the agreement.”
Under the Investment Funds Act, subparticipation involves a securitisation fund as the acquirer of an interest in the receivable from an initiator. Subparticipation involving other parties is known as “private” subparticipation.
In economic terms, the initiator seeks to free itself from the risk connected with the receivable (primarily the risk of the debtor’s insolvency) and to improve its cash flow (as the receivable may not become due until later, thus postponing the creditor’s satisfaction). These goals may be met by an assignment of the receivable, in which the creditor sells the receivable outright, thus passing on the risk of the debtor’s insolvency and obtaining immediate cash flow. The same goal can be achieved by subparticipation, in which the creditor does not assign the receivable but, in exchange for immediate cash, promises to transfer to the subparticipant all of the receipts the creditor obtains from the debtor, if and when it obtains them.
Unlike an assignment of the receivable, the original creditor remains the creditor of record and the receivable remains on its books as an asset of the original creditor. Subparticipation may be sold by the creditor of record without the restrictions that could apply to a sale of the receivable itself, such as contractual limitations on assignment of the receivable or the need to re-register a mortgage securing the receivable. The common concern about the effectiveness of the assignment is eliminated. The debtor need not be notified or aware of the subparticipation. Thus the logistics can be much simpler than with assignment, particularly when a large portfolio of receivables is involved.
A drawback compared to assignment is that because the initiator remains the creditor of record, it will be responsible for taking measures to enforce the receivable. And the subparticipant will not be permitted to satisfy the claim by setting off any claims the debtor has against it—which can be an important reason for assignment of receivables. In that case, subparticipation would not be a good solution.
The prohibition of postponement of payment to the initiator in a subparticipation agreement may present doubts in interpretation in practice, as many securitisation or factoring agreements provide for some form of reserve to secure potential claims against the initiator. Practice (or case law) will show whether such reserves are regarded as violating the prohibition on postponement of payment to the initiator.
With qualified subparticipation, securitisation funds enjoy special protection under bankruptcy law. Under Art. 65a of the Bankruptcy & Recovery Law, in the event of the bankruptcy of the initiator of a subparticipation agreement, the receivable which is the subject of the subparticipation does not become an asset of the bankruptcy estate, but the securitisation fund enters into the rights of the debtor in the bankruptcy proceeding under the receivable and the bankruptcy trustee transfers to the securitisation fund any receipts it obtains from the debtor of the receivable or from enforcement of security for the receivable. It appears from the literal wording of this provision that it applies even if the subparticipation agreement does not provide for the securitisation fund to assume the risk of the initiator’s insolvency. It thus avoids the risk which exists in the case of assignment that a “true sale” of the receivable will be reclassified as an assignment for security.
An advantage of assignment of receivables is the great flexibility concerning which entities may be involved as buyers or sellers of receivables. Under the Investment Funds Act the subparticipant in subparticipation must be either a securitisation fund (or a fund management company forming a securitisation fund). And, as will be seen, the tax regulations also draw distinctions among initiators of subparticipation. Thus there are serious limitations in practice on the set of parties which can take full advantage of subparticipation.
An additional wrinkle concerning the entities involved in subparticipation in Poland should be pointed out. Under a literal interpretation of the Banking Law and the CIT Act, a Polish bank may obtain favourable tax treatment of subparticipation only if the subparticipant is a Polish securitisation fund. Such interpretation, discriminating against securitisation funds from other EU member states, would appear to violate the principle of free flow of capital within the EU.
Tax treatment of subparticipation
Secure and effective use of subparticipation requires not only careful drafting of the subparticipation agreement but also consideration of the tax effects of subparticipation.
- Corporate income tax
The amendment to the CIT Act as of 1st January 2014 enabling banks to treat as revenue-earning costs the receipts under securitised receivables which the bank transfers to subparticipants, while postponing the recognition of income in the form of the price paid for the subparticipation until payment or maturity of the receivable, may result in an increase in the use of subparticipation as a structure for banks to sell their loan portfolios.
On the revenue side, under CIT Act Art. 12(4)(15)(c) and Art. 12(4f), the revenue obtained by a bank for transferring to a securitisation fund under a subparticipation agreement the right to an income stream under loans made by the bank is not recognised as taxable income for the bank at the time it sells the subparticipation to the fund (Art. 12(4)(15)(c)), but is recognised (pro rata) only when the loan instalments fall due, or are actually paid in the case of early payment (Art. 12(4f)).
Meanwhile, on the cost side, under CIT Act Art. 15(1h)(3), receipts obtained by a bank pursuant to securitised receivables (through payment by the debtor or enforcement of security) and transferred to a securitisation fund pursuant to a subparticipation agreement are treated as revenue-earning costs for the bank. Moreover, under CIT Art. 16(3g), the bank may reduce the value of reserves created to cover receivables and revaluations concerning receivables covered by subparticipation by the amounts obtained under the subparticipation agreement, and such reserves may be recognised as a revenue-earning cost to the extent that the income is recognised under Art. 12(4)(15)(c).
With these special rules in effect for banks acting as the initiator of subparticipation, the income and costs from sale of the subparticipation are generally recognised at the same time, and are deferred until payment is made under the receivable.
In private subparticipation, by contrast, these special CIT rules for subparticipation do not apply. Consequently, under one approach, the initiator of private subparticipation recognises taxable income up-front, upon receipt of the payment from the subparticipant, but only recognises a revenue-earning cost later, upon transfer to the subparticipant of the receipts under the receivable. Under another approach, because the initiator does not obtain a definitive augmentation of its wealth upon receipt of amounts due under the receivable, but must pass them on to the subparticipant, the amounts received and passed on to the subparticipant are tax-neutral. However, the fee paid by the initiator for the subparticipant’s assumption of the risk of the debtor’s insolvency should be recognised by the initiator as a revenue-earning cost.
The income tax consequences for the subparticipant will also depend on whether it is qualified subparticipation or private subparticipation. This is straightforward in the case of qualified subparticipation because investment funds generally enjoy a subjective exemption from corporate income tax.
In the case of private subparticipation, the tax authorities take the view that the amounts received from the initiator constitute taxable income, and the amounts paid to the initiator to purchase the subparticipation, because they are directly related to the income, may be recognised as an offsetting revenue-earning cost at the same time the income is recognised. This means that the private subparticipant may face a doubly negative effect if the debtor defaults, because it would suffer a direct loss from not receiving payment from the initiator and would not be able to recognise some of the actual costs incurred in performing the subparticipation agreement.
For these reasons, subparticipation requires careful income tax planning. Although greater difficulties are presented by private subparticipation, qualified subparticipation raises issues as well—for example, whether the tax advantages discussed above will be available if the subparticipation involves a foreign investment fund, whose form may not fully correspond to that of a securitisation fund as defined under Polish law. The treatment of reserves and revaluation by banks acting as initiators of subparticipation may also not be entirely clear, and the calculation for tax purposes may differ from the calculation for balance sheet purposes, thus complicating the bank’s financial reporting.
The VAT consequences of subparticipation also require analysis, considering the number and types of services performed under a subparticipation agreement by both parties and the correct VAT rate to be applied.
With respect to the financial function, subparticipation should enjoy a VAT exemption under Art. 43(1)(38) for the service of lending and intermediation in performance of lending and administration of loans by lenders. Lending should be understood, under the general rule for interpretation of VAT regulations, consistent with its economic nature, as any form of financing (and not just a “loan” as defined in Civil Code Art. 720). Meanwhile, the del credere or surety function of subparticipation, related to the subparticipant’s assumption of the risk of the debtor’s insolvency, should enjoy a VAT exemption under VAT Act. 43(1)(39) for guarantees and other security for financial transactions and related intermediation and administration.
The actions undertaken by the subparticipant should also fall within the scope of debt-related services as referred to in VAT Act Art. 43(1)(40), because the entire subparticipation process involves debt. The subparticipant’s role does not appear to involve debt collection or factoring services which are subject to 23% VAT under VAT Act Art. 43(15)(1). Nonetheless, it cannot be excluded that the initiator of the subparticipation will be required to take such measures, in which case two different transactions could be identified in subparticipation—a service by the subparticipant exempt from VAT and a taxable service by the initiator. This approach would be particularly unfavourable for the bank, which, with its ability to deduct input VAT limited by its VAT factor, would be required to charge 23% output VAT.
But in one interpretation (No. IPPP1/443-74/1202/AW, 6 April 2012), the director of the Warsaw Tax Chamber interpreted the VAT exemptions narrowly and concluded that the services performed under a subparticipation agreement are not exempt from VAT.
Given the lack of established practice on the VAT treatment of subparticipation, any steps that are not carefully thought through could have dire consequences for the parties, particularly if significant amounts had to be set aside to pay VAT. There is thus a very real need for careful analysis of subparticipation agreements in this light.
- Transaction tax
There is less doubt surrounding the issue of application of the tax on civil-law transactions to subparticipation agreements. Whether as a specific type of agreement defined in Investment Funds Act Art. 183(4) or as an unclassified agreement (private subparticipation), it should not fall within the exhaustive list of transactions covered by the tax. (By contrast, in the case of assignment of receivables, based on the ruling of the European Court of Justice in Finanzamt Essen-NordOst v GFKL Financial Services AG (Case C-93/10, judgment of 27 October 2011), where defaulted receivables are sold for below face value, the price may reflect the economic value of the receivables and thus, in Poland, would be subject to the 1% transaction tax.). However, still some tax authorities tend to approach that 1% transaction tax should apply. Therefore, it may be worth considering to undertake additional measures to secure tax position, e.g. by applying for the binding tax ruling.
The foregoing overview of the tax implications of subparticipation agreements indicates just a few of the potential doubts that arise in this area. For greater security against negative tax consequences, apart from a thorough analysis of the specific transaction the parties could also seek an individual tax interpretation—particularly when large sums are involved.
As these issues become clarified in practice, it is expected that subparticipation will be used increasingly by banks in Poland to generate free cash by securitising their loan portfolios, in place of the more traditional practice of assignment of the bank’s receivables under the loans.
Krzysztof Wojdyło, Payment Services Practice, and Joanna Prokurat, Tax Practice, Wardyński & Partners