Many years ago I worked in the private sector in one of the most lucrative areas of tax consulting: transfer pricing. By adjusting transfer prices -- for example, by raising prices paid by a U.S. parent company for products from its subsidiary in low-tax Ireland -- a multinational could save a fortune in taxes. The IRS had the authority to reset transfer prices if it thought they did not reflect economic reality. The name of the game for companies and their armies of consultants was to convince the IRS agents that a low-tech Irish manufacturer was a fountainhead of innovation and to act as though the parent company's multi-billion research division did not even exist. If this story could be convincingly told, the bulk of the profits could be assigned to Ireland, and millions in taxes would be saved. The fantastic levels of Irish profitability recorded in official U.S. data demonstrate that the IRS was convinced.
But over time the multinationals learned that in addition to hiring high-priced consultants, another way to get the IRS off their backs was to actually relocate high-value activity to Ireland. This made the IRS happy. The IRS agents were no longer being fooled. Transfer prices were no longer being manipulated: there was real value in those Irish subs. And so the IRS unwittingly utilized its considerable power to push jobs and technology out of the United States.
Unfortunately, transfer pricing may not be the only example of situations where "good tax policy" leads to lousy economic outcomes. At the heart of the current financial meltdown is the securitization of subprime mortgages. A major problem with these paragons of modern finance is that the guys making the loans -- the swash-buckling "body-builders" in Chapter 8 of Larry McDonald's riveting saga of the Lehman collapse -- had massive incentives ("double commissions," in the McDonald book) to practice predatory lending on borrowers and to dupe the investors buying the mortgages packaged by Wall Street and stamped "AAA" by credit rating agencies.
In 1986, in order to streamline the clunky tax law concerning mortgage securitization, Congress created Real Estate Mortgage Investment Conduits ("REMICs"). The assets of a REMIC are individual mortgages. The main problem under prior law is that when securitization vehicles issu ed multiple classes (tranches) of securities, the IRS considered that too much activity to allow pass-through treatment, and the entity was subject to corporate level tax. The new legislation got rid of the corporate level tax as long it only engaged in a tightly limited set of activities. (This same tax concept is what limits the activities of mutually funds, called Regulated Investment Companies ("RICs") by tax professionals.)
During the pre-2007 credit boom REMICs tranches themselves were often resecuritized in collateralized debt obligations (CDOs). To attract pension funds, real foreign investors, and U.S. investors pretending to be foreigners, the off-balance-sheet CDOs used by banks and investment houses were set up as offshore corporations -- usually in the Cayman Islands. Even though these entities typically hold U.S. assets and are organized and managed by U.S. financial institutions, they can avoid the deal-killing blow of being subject to U.S. corporation tax by jumping through some hoops. Without going through the details, the basic idea is that an offshore corporation must show it is more passive than active.
As with REMICs, the tax policy guys at the Treasury Department insist on this because they want to "preserve the corporate tax base." So, the way they see it, if you meet their arbitrary requirements for not doing what they consider to be normal corporate activity, they are fine with that.
So when lawyers get their input into securization design they make sure the entity actions are robotic. For REMICs, there must be a fixed pool of securities with no active management of the portfolios. For CDOs they insist on structures where the entity can be viewed as a "mere investor" rather than an ongoing "trade or business." And, if it has the misfortune of being considered a trade or business, it must be structured to be eligible for a statutory exception for "portfolio" investments. In other words, the activities taking place at the entity level must be seen by the IRS as so insignificant that the whole entity should be ignored for tax purposes and the income should just "flow-through" without being taxed. To achieve this critical tax objective the companies collecting the fees -- the Wall Street banks and investment houses -- have to put the securitizations on auto-pilot. For one thing, this means there has to be an identifiable separation between the mortgage originator and the special purpose vehicle.
Economists are now arguing a great deal about whether this "atomization" or "vertical disintegration" of traditional banking has been a net plus or minus for U.S. financial markets. But it is clear that one titanic problem with securitization is its role in the collapse of underwriting standards. It is widely acknowledged that if issuers do not have "skin in the game" they will not have adequate incentive to maintain credit quality. The policy response to this problem, as noted in a just-released IMF report (pp.24-25), is requiring originators to hold a portion of all securities they issue.
In general tax rules also require that once the securitization portfolio is in place, its management must continue to keep hands off to avoid entity-level tax. Among other things this means no workouts or refinancings -- the kind of roll-up-the-sleeves work that local bankers used to do -- the kind of nuts-and-bolts work that is still needed to help mitigate losses for investors and suffering for homeowners and that is still in such critical short supply. And although it may be difficult to sympathize with the Mortgage Bankers Association, it is exactly correct on this point:
- The requirement that a REMIC pool must be passive has been a significant burden on the efficient operation of the commercial mortgage marketplace. The tax code’s requirement for passive loan pools results in the prohibition on material changes in the loan once it is in a REMIC pool. Since mortgage loans are long-term assets, borrowers inevitably encounter situations where changes to the loan terms or the underlying property are necessary. Often these changes cannot be accomplished because of the REMIC restrictions regardless of the often positive impact on the property’s economic value and, therefore, the security for the investors.
As always, tax laws should promote neutrality. They should not interfere with efficient business practices that follow from the underlying economics. Sometimes a lack of neutrality is no big deal, but in the case of subprime securitization the problem is huge. My solution would be to collect one layer of corporate tax on all securitization deals and then let them be structured with any degree of activity (including origination and restructuring) that makes economic sense. One way of doing this would to subject all securitization profits (including all fees to servicers and originators) to a withholding tax that is creditable against corporation tax.
The implication of this proposal is that securitizations should continue to be tax-free at the entity level as long as the dealmaker -- the Wall Street financier -- is paying corporate tax on the huge fees it generates for underwriting and servicing the securitization. (Please remember, just because a REMIC pays no corporate tax does not mean it is getting a tax break. Also, please remember that just because a CDO securitization takes place in Cayman does not mean it is necessarily "aggressive" tax avoidance to gain tax advantages. In these situations, the issuers are mostly engaged in "defensive" planning to prevent a punitive double tax.) This would make the tax treatment of traditional banking and securitization neutral -- i.e., the profits of both would be subject to 35-percent corporate tax (in addition to whatever investor level taxes apply). It would also remove prohibitive tax penalties on banking services that are critical to preventing the problems at the center of our current crisis.