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CURRENT FEDERAL INCOME TAX DEVELOPMENTS INCLUDING THOSE AFFECTING FINANCIAL PRODUCTS AND POSITIONS
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Panelists:
Robert Shapiro, Société Générale (Moderator)
Lucy Farr (Davis, Polk & Wardell, LLP)
Julio Jiménez (PWC, LLP)
Mark Leeds (Mayer Brown)
Amanda Varma (Steptoe & Johnson, LLP)
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Agenda: 1. Section 871(m) 2. Swap Compensating Payments 3. IRS Use of Debt Rules 4.Deposits with the Federal Reserve 5.Tax Legislation Overview and Outlook
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1. Section 871(m): Where are we now?
ISDA 2010 Protocol Issues?
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SNPCS and 2016 – Where are we?
u Treasury indicated Proposed Regulations Effective 2017 at Various Conferences
u Question on the Currently Effective Provisions:
u Under section 871(m)(3) the definition of a “specified NPC” (SNPC) varies depending on the time period:
I. From 2010-2012: Under section 871(m)(3)(A) if the contract has any of the four elements:
u (1) Cross-in,
u (2) Cross-out,
u (3) Illiquid underlying, or
u (4) Underlying posted as collateral,
u it will be a SNPC. This was extended by regulation until 12/31/15.
u II. From 2012 onward: Under section 871(m)(3)(B), ALL NPCs will be considered SNPCs unless Treasury says otherwise:
u “871(m)(3)(B) – in the case of payments made after the date which is 2 years after the date of the enactment of this subsection, any notional principal contract unless the Secretary determines that such contract is a type which does not have the potential for tax avoidance.”
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ISDA HIRE Protocol – Impact and Points
u Section 871(m) IS CURRENTLY EFFECTIVE with Final Regulations through 2016.
u Current Definition of Indemnifiable Tax insufficient?
u Current Termination Event Language insufficient?
u Short Form vs Long Form?
u Market Resistance?
u The protocol (i) eliminates the normal gross-up that would apply for withholding tax purposes, (ii) allows for termination of a swap if payments become subject to withholding under the HIRE Act provisions, and (iii) amends payee representations to account for the HIRE Act.
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Indemnifiable Tax u “Indemnifiable Tax” means
u - any Tax
u +other than a Tax that would
u ++not be imposed in respect of a payment
u under this Agreement
u +++but for a present or former connection
u between the jurisdiction of the government or taxation authority imposing such Tax
u and the recipient of such payment or a person related to such recipient
u (including, without limitation, a connection arising from
u - such recipient or related person being or having been a citizen or
u resident of such jurisdiction,
u - or being or having been organized, present or engaged in a trade or business
u in such jurisdiction,
u - or having or having had a permanent establishment or fixed place of business in
u such jurisdiction,
u ++++ but excluding a connection arising solely from
u such recipient or related person having executed, delivered, performed its obligations or
u received a payment under, or enforced, this Agreement or a Credit Support Document).
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ISDA 2010 Short Form Hire Act Protocol
u Long Party Payee Representation for any Transaction where the Transaction provides for one or more amounts that may (directly or indirectly) be contingent upon or be determined by reference to a dividend from sources within the United States and the Long Party did not represent that either it is a US Person or is not a US Person with US ECI:
u The Long Party represents that (A) it has not transferred and will not transfer the underlying security to Short Party in connection with its entering into such Transaction, and (B) it will not acquire the underlying security from Short Party in connection with the termination of such Transaction; and if the Long Party is not a Dealer (x) if the opening price of the Transaction is determined by reference to “market on close” (“MOC”) or “market on open” (“MOO”) on a given day or days, it has not in connection with entering into the Transaction put in a sell order for the underlying security at MOC or MOO, respectively, on such given day or days and (y) in the event that the closing price on such Transaction is or will be determined by reference to MOC or MOO on a given day or days, it will not in connection with the termination of the Transaction put in a buy order for the underlying security at MOC or MOO, respectively, on such given day or days.
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ISDA 2010 Short Form Hire Act Protocol
u Short Party Payer Representation for any Transaction where the Short Party is not a Dealer, the Transaction provides for one or more amounts that may (directly or indirectly) be contingent upon or be determined by reference to a dividend from sources within the United States and the Long Party did not represent either that it is a US Person or that it is not a US Person with US ECI;
u The Short Party represents that (x) if the opening price of the Transaction is determined by reference to “market on close” (“MOC”) or “market on open” (“MOO”) on a given day or days, it has not in connection with entering into the Transaction put in a buy order for the underlying security at MOC or MOO, respectively, on such given day or days and (y) in the event that the closing price on such Transaction is or will be determined by reference to MOC or MOO on a given day or days, it will not in connection with the termination of the Transaction put in a sell order for the underlying security at MOC or MOO, respectively, on such given day or days
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2. IRS Temporary Regulations on Swap
Compensating Payments
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1993 Final Swap Regulations
u Existing regulations require a bifurcation of an off-market swap into an on-market swap and a loan only if the nonperiodic payment is “significant.”
u The existing regulations provide 2 examples, one in which the upfront payment is significant and another in which the upfront payment is not significant.
u Regulations do not offer any guidance on where the line should be drawn.
u In the absence of a swap counterparty “borrowing money on from a swap desk,” market practice has been not to bifurcate swaps.
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Market Cleared Swap Collateral Requirements
u Dodd-Frank requires that swap counterparties facing an exchange post specified collateral amounts (initial margin).
u Swaps are marked to market for collateral purposes (variation margin).
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Temporary Regulations Require Bifurcation
u Bifurcation is required regardless of whether the non-periodic payment is significant with 2 exceptions:
u Swaps with durations of one year or less – only applies if fully collateralized exception is unavailable. Does not affect whether loan creates UBTI.
u Swaps subject to prescribed margin requirements. Swap must be centrally cleared & subject to initial & variation margin requirements. Collateral must be posted in cash, not cash equivalents. Exception is unavailable if variation margin falls belows 100% or is in excess of 100%.
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Certain Consequences of Embedded Loans
u Withholding on interest u Tax Reporting for Interest
(Swaps are generally exempt from interest reporting under section 6049)
u UBTI u Code section 956 u Systems requirements
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3. IRS Use 0f Debt and Interest Rules
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IRS Use of the Debt Modification Rules to Non-Debt Financial Instruments
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Background on the Significant Modification Regulations
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Modifications of Financial Instruments - Inquiry
u A modification of a financial instrument may be so substantial that the modification amounts to an exchange of the pre-modified (old) instrument for the post-modified (new) instrument.
u The parties may desire to cloak an exchange as a non-taxable modification to avoid income or gain recognition.
u Even if the modification is an exchange, a current loss may not be available
u Reorganization rules may require basis carry-over
u Wash sale rules may defer the loss
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IRS Issues Regulations For Certain Debt Instruments
u In response to the holding of Cottage Savings, the IRS issued regulations in 1990s that govern when certain modifications will result in a deemed exchange.
u A modification is any alteration of a legal right or obligation of the legal rights of the issuer or the holder.
u Treas. Reg. § 1.1001-3(a)(2) provides that the regulations do not apply to tax-exempt bonds that are qualified tender bonds.
u The failure of an issuer of a debt instrument to perform its obligations under the debt is not a modification. Treas. Reg. § 1.1001-3(c)(4).
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Other Exceptions to When a Modification Occurs
u A holder’s temporary forbearance to collect a debt instrument is not a modification if:
u There is no agreement to alter the debt instrument
u The forbearance lasts 2 years or less, or if greater than 2 years, the parties are conducting good faith negotiations
u Modifications occurring pursuant to the terms of a debt instrument are not treated as modifications
u Modifications occurring pursuant to unilateral options within the debt instrument are not treated as modifications.
u But if a holder option reduces or defers principal or interest, exercise of the option results in a modification
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Overrides to the Exceptions u Certain changes will always result in modifications, even if
pursuant to the terms of the debt instrument or a unilateral option:
u Substitution of obligor
u Addition or deletion of an obligor
u Change from recourse to non-recourse (or vice versa)
u Change in the nature of the instrument from debt to non-debt (unless pursuant to a unilateral right to convert debt into equity)
u A modification results in a deemed exchange only if the modification is significant.
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Defeasance Rules u De facto defeasance: Issuer remains liable for debt, but is
released from covenants because of deposit of securities sufficient to repay debt. De facto defeasance is not a modification. Treas. Reg. § 1.1001-3(d)(Ex. 5).
u Legal defeasance: Issuer is relieved of all obligations under the debt instrument. Legal defeasance is a substantial modification because the debt is converted into non-debt, that is, ownership of the defeasance assets.
u Legal defeasance rules do not apply to tax-exempt bonds if permitted by terms of instrument & gov securities are used to effect the defeasance.
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Significant Modifications u Change in Yield by more than the greater of 25 bps and 5% of the annual yield of the unmodified instrument.
u Commercially reasonable prepayment penalties are ignored. u Deferral of Payments. Extension of the maturity of the debt by more than the smaller of 50% of the original term or 5 years is a significant modification, as is a change in yield of more than the greater of 25 basis points or 5% of the original yield. u Change in Security. An alteration of a substantial amount of collateral on a nonrecourse debt instrument, unless collateral in fungible. u Change in Obligor on a recourse debt instrument is a significant modification.
u Exception for reorganizations provided that substitution does not result in a change in payment expectations & there is no significant alteration to the debt. u Exception for tax-exempt bonds if the new obligor is related to original obligor u Exception for bankruptcy filings
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Additional Significant Modifications u The following changes to a debt instrument
are significant modifications if they result in a change in payment expectations:
u Addition or deletion of an obligor u A change in credit enhancement u A change in debt priority
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Recent Developments on the Application of the Significant
Modification Regulations
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Estate of McKelvey u Taxpayer enters into variable prepaid forward contracts.
Contracts allowed monetization of publicly-traded stock without triggering a constructive sale under Code § 1259.
u Stock was trading at $32. Floor was $30.894 and cap was $35.772.
u Before contracts came due, the parties extend them for 3x their original term. There were no other changes.
u It appears that the IRS asserted that the extensions triggered gain when made (2008).
u Stock fell to $14 when contract expired.
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Estate of McKelvey Tax Issues u Did the extensions trigger gain?
u Extension of options trigger gain. Reily v. Comm’r.
u Extension of power purchase contracts did not trigger gain
u If the forward contracts were significantly modified, did the taxpayer recognize gain?
u The forward contracts became very valuable because they went in-the-money (COD income)
u If there was a significant modification, did the constructive sales rules apply to the stock?
u Contract price no longer collared the stock
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PLR 201443015 u Subsidiaries of publicly-traded company wrote grandfathered
life insurance contracts.
u Subsidiaries assigned insurance contracts in connection with exiting life insurance business. Assignment required insureds’ consents
u If assignment was a material change, then insureds would have recognized gain inherent in policies
u 3 bases for IRS ruling that no gain was recognized
u Policyholders did not initiate change.
u Assumption did not change existing obligations
u No change to contract terms
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PLR 201431003 u Consent payments were made on contingent payment debt
instruments by a bond issuer that was planning a split-off to obtain bond holder consent for the transaction.
u Rule as to whether payments change yield by lesser of 5% and 25 bps does not apply to CPDIs.
u Consent payments were not provided for by terms of original debt instruments and they clearly increased the yield on the bonds.
u IRS treated payment as a “positive adjustment” under CPDI rules & then used existing regulation test for materiality.
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PLR 201431003 – Ignored Inaja Land u Inaja Land – Taxpayer receives a payment, less than the cost of
the land, from the City of Los Angeles, to allow the City an easement over the land.
u Taxpayer successfully asserted that payment was for an inseparable portion of its rights in the land.
u Taxpayer was allowed to treat the payment as a basis reduction and not as a taxable payment.
u Consent fees in PLR 201431003 bear a strong resemblance to the payment for the easement.
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Advice Memorandum 2014-009 u Municipality issued Build America Bonds (BABs)
u Election allowed municipalities to issue taxable bonds and receive subsidy from Federal Government equal to tax benefit if municipality issued tax-exempt bonds or issue the BABs as tax-exempt obligations
u Municipality in question chose to issue taxable bonds & receive the subsidy.
u In July 2014, Congress ceased subsidy payments, allowing the municipality to redeem the bonds.
u Municipality refinanced the bonds with lower interest rate bonds.
u Rules treating de jure defeasances as taxable exchanges do not apply to tax-exempt bonds.
u IRS refused to treat these BABs as tax-exempt bonds.
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CCA 201442052
u Taxpayer, an insurer, purchased options by paying the premium in a series of payments over time
u Contracts characterized the payments entirely as premium payments, without interest
u Taxpayer sought to deduct a portion of the payments as interest, determined by comparing the amounts of the payments to the amount it would have paid upfront for the same options
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CCA 201442052 (cont.)
u The IRS concluded that the payments should not be characterized as bearing interest:
u It rejected the taxpayer’s analogy to Treas. Reg. 1.446-3 as “irrelevant,” since the transactions were options rather than notional principal contracts
u It relied on the taxpayer’s form for the transaction
u It concluded that Section 483 was inapplicable by its terms
u See also Koch v. Comm’r, 67 T.C. 71 (1976) (holding that option premium paid over a five year period was not interest)
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Imputed Interest on Non-Swap Derivatives?
u Representatives of Treasury and the IRS have stated publicly that they are actively working on regulations to address contingent payment swaps, and that those regulations might also address prepaid forwards and other derivatives
u Significant issues regulations will need to address: u Scope - apply rules uniformly to all derivatives?
u Typical options are “prepaid,” although the prepayment is relatively small
u Timing – use a relatively fixed accrual, as in the CPDI regulations, or update more frequently?
u Tradeoff between simplicity and more precise reflection of income
u Character – retain potential for capital gain?
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CCA 201515020 (Leveraged Forward)
u The CCA describes a transaction whereby the taxpayer borrowed money and simultaneously purchased prepaid derivative contracts
u Payments received on the derivative (“Bond Delivery Face Amount Payments”) matched interest payments on the loan
u There was a small amount of potential for economic gain on the derivative based on interest rate movements u Promoter had effectively purchased the exposure by buying a
swaption
u Taxpayer deducted the interest payments and did not include in income the payments received on the derivative
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CCA 201515020 (cont.)
u CCA denies the deduction on the basis of the common law economic substance doctrine:
u Highly structured transaction
u Unnecessary steps
u Taxpayers paid more for the transaction than it was worth
u Offsetting positions
u Very limited potential for profits
u Tax motivation
u CCA doesn’t bother to analyze the technical treatment of the transaction (e.g., whether the taxpayer should have included payments on the contract in income) in light of its economic substance conclusion
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4. Deposits with the Federal Reserve as Securities for
Interest Expense Allocation
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Deposits with the Federal Reserve
u Treas. Reg. Sec. 1-882-5 relies on 1.884-1 for US Asset Definition.
u Treas. Reg. Sec. 1.884-1 looks to 1.864-4 ECI principles.
u Treas. Reg. Sec. 1.864-4(c) introduces three tests: Business Activities, Asset Use, and Special Baking rule.
u Special Banking Rule vs Business Activities vs Asset Use.
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5. Tax Legislative Overview and Outlook
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Overview
u Outlook for tax reform
u Focus on interest deductibility and 163(j)
u Proposals targeting the financial industry
u Bank tax
u Financial transaction taxes
u Financial instruments reform proposals
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Outlook for Tax Reform
u General agreement on broad principles
u U.S. statutory corporate tax rate is high
u U.S. international tax system is outdated
u Temporary tax provisions (e.g., extenders) should be made permanent or eliminated
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Outlook for Tax Reform
u But disagreements on the details
u How to pay for a lower corporate tax rate, if at all?
u What to focus on? Corporate, international, and/or individual tax reform? Financial instruments?
u Should corporate integration be used to eliminate/minimize the double taxation of corporate profits?
u Exempt foreign earnings from U.S. tax? Tax all foreign income currently? Modify subpart F rules?
u Are rules needed to address inversions, or otherwise change the taxation of foreign-owned companies investing in the United States?
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Outlook for Tax Reform
u Recent developments u Senate Finance working groups
u Highway Trust funding
u Recent proposals u Former Ways & Means Chairman Camp’s tax reform proposal
u Obama Administration
u Greenbook proposals
u 2012 Framework for Business Tax Reform
u Others – Wyden, Baucus, etc.
u Recent proposals set the stage for discussion, and ultimately possible reform in the long-term, but also potential revenue-raising in the short-term u Interest deductibility
u Proposals targeting financial industry
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Interest Deductibility – Current Law
u Businesses may generally deduct interest expense
u Limitations
u Debt/equity distinction
u Transfer pricing (interest rate must be arm’s length)
u Section 163(j)
u Deduction for related-party interest expense may be disallowed if taxpayer’s net interest expense exceeds 50% of adjusted taxable income and the taxpayer’s debt-to-equity ratio exceeds 1.5 to 1
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Interest Deductibility - Current Focus
u Why attention to interest deductibility?
u Revenue
u BEPS and concerns about base erosion
u Inversions
u Concern that deductibility of interest creates a bias in favor of debt financing
u Concern that financial institution leverage contributed to the financial crisis
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Interest Deductibility - Proposals
u Camp Tax Reform Act of 2014
u Proposes to tighten the section 163(j) interest deduction limitation to 40% of a corporation’s adjusted taxable income, compared to the 50% limitation under current law
u Would also introduce a new thin capitalization rule for U.S.-headquartered companies
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Interest Deductibility - Proposals
u Obama FY 2016 Greenbook
u For a U.S. member (or U.S. subgroup) of a foreign-parented group, the deduction for interest would be limited if the member’s net interest expense for financial reporting purposes exceeds the member’s proportionate share (determined by earnings) of the group’s net interest expense
u If can’t substantiate share of net interest expense, or if member elects, interest deduction is limited to member’s interest income plus 10% of adjusted taxable income
u Limitation applies to net interest expense
u Exception for financial services entities
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Interest Deductibility - Proposals
u Wyden-Coats Bipartisan Tax Fairness and Simplification Act
u Disallow deduction for portion of interest expense that is attributable to inflation
u President’s Economic Recovery Advisory Board (PERAB)
u Limit deductibility of net interest to 90% of expense in excess of $5 million
u Others
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Tax Proposals Targeting Financial Industry
u There have been several proposals to target the financial industry for revenue-raising over the past several years
u Bank taxes
u Camp and Greenbook proposals
u Financial transaction taxes
u Likelihood of passage?
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Bank Tax - Proposals Camp Excise Tax Obama Financial Fee
(FY 2016 Greenbook)
Covered financial institutions
“Systemically important financial institutions” (under Dodd-Frank) with greater than $500 billion in total consolidated assets (as reported to Federal Reserve)
Banks, bank holding companies, insurance companies, asset managers, broker-dealers, etc. (including U.S. subsidiaries or branches of foreign entities) with worldwide consolidated assets of $50 billion or more
Tax Base Total consolidated assets exceeding $500 billion
Total assets less equity for banks
Tax Rate .035%, imposed quarterly
Seven basis points, imposed annually
Justification for Tax
“Recapture ‘implicit subsidy’ of Dodd-Frank”
“Reduce the incentive for large financial institutions to leverage”
Revenue Estimate
$86.4 billion $111 billion
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Financial Transaction Taxes (FTTs)
u Several recent U.S. FTT proposals would impose a tax on financial transactions cleared in the United States or involving a U.S. person
u Example – “College for All Act” (S.1373) which would impose a FTT of .5% on stock trades, .1% on bonds, and .005% on derivatives to offset the cost of financing undergraduate tuition and lowering interest rates on student loans
u Obama Administration has been opposed to FTTs
u “Robin Hood Tax” movement
u EU has been considering an FTT for several years
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Financial Instruments Reform u Former Ways and Means Chairman Camp’s Tax Reform Act of 2014 proposed reforming
the tax treatment of financial instruments
u Currently, not a significant amount of attention to this area on the Hill
u Camp’s proposals included:
u Mark-to-market for all derivatives, regardless of whether linked to a publicly-traded security
u FY 2016 Greenbook also proposes mark-to-market for derivatives the value of which is determined, directly or indirectly, in whole or in part, by the value of actively traded property
u Permit taxpayers to rely on, for tax purposes, an identification of a transaction as a hedge that has been made for financial accounting purposes
u Require purchasers of bonds at a discount on the secondary market to include the discount in taxable income over the post-purchase life of the bond
u Modify rules governing issue price and gain/loss with respect to modified debt instruments
u Require taxpayers selling substantially identical stock to determine gain/loss on “first-in, first-out” (FIFO) basis
u Expand wash sale rules to disallow (not defer) losses where certain related parties acquire substantially identical securities within 30 days before or after the disposition
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Questions??
u THANK YOU FOR YOUR ATTEDNANCE AND ATTENTION!!
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