US Taxation of Financial Products: A Mid-Year Update IFLR

1. US Taxation of Financial Products: A Mid-Year UpdateIFLR July 16, 2013 Thomas A. Humphreys Remmelt A. Reigersman NY 1098522

2. Agenda • Introduction • Ambac—Tax Treatment of Credit Default Swaps • Notice 2013-48 – Wash Sales/Money Market Fund Shares • FATCA Update • Debt vs. Equity • Trust Preferred Securities • Contingent Convertible Bonds • Caselaw Developments • U.S. View • Excess Mortgage Servicing REIT • Basket Option Contracts • Tax Reform? • Structured Notes

3. Current U.S. Tax Rates

4. Ambac CDS • AMBAC’s subsidiary (AMBAC Assurance Corporation) was in the financial guarantee insurance business • AAC wrote credit default swaps (“CDS”) on asset/mortgage backed securities, many of which were rated “AAA” • AAC received periodic payments from third parties and agreed to pay the loss, if any, upon a default • When the financial crisis hit, the AMBAC consolidated group claimed over $4 billion in ordinary losses relating to its CDS and carried the loss back for a $700 million IRS tax refund • AMBAC’s parent filed for federal bankruptcy protection in November, 2010, largely because of fear the IRS would try to clawback the refund

5. Ambac CDS • Tax issue: Whether losses on CDS were capital or ordinary and whether they were currently deductible (AMBAC’s position) or deductible only when paid (IRS position)? • IRS Notice 2004-52: IRS seeks “further information” on CDS • Prop. Reg. section 1.446-3(c)(1)(iii) [September 16, 2011]: CDS are notional principal contracts entitled to ordinary income and loss treatment

6. Settlement (Announced April 9, 2013) • AMBAC will pay the Government $101.9 million. • AMBAC liable for possible future additional payments of up to $14.9 million. • AMBAC will reduce its net operating loss carryovers attributable to the CDS contracts at issue by $1 billion. • Manhattan U.S. Attorney Preet Bharara: “The proposed settlement reflects an extensive investigation into Ambac’s reported financial losses and accounting methods in the wake of the financial crisis, and, if approved, will result in a significant recovery of Treasury funds. The settlement will also prevent Ambac from taking $1 billion in future offsets against its income and thus potentially reducing its tax burden by several hundred million dollars, a reduction to which it is not entitled.”

7. Notice 2013-48—Wash Sales/Money Market Fund Shares • Issue: SEC proposal that certain money market funds will not maintain a $1 per share net asset value • This raises the prospect that a shareholder could redeem shares at a loss, then reinvest within the 30 day wash sale period and have the loss deferred under IRC § 1091 • Notice 2013-48: 0.5% de minimis standard where IRS will not disallow loss under wash sale rules

8. FATCA Update • Foreign Account Tax Compliance Act (2010)—Designed to Find “Undisclosed” Foreign Bank Accounts Held by U.S. Taxpayers • New IRC Section 1471: A Withholding Agent Must Withhold 30% on All “Withholdable Payments” Made to a Foreign Financial Institution Unless the FFI Signs an Agreement with the IRS to Information Report on its U.S. Account Holders • A “Withholdable Payment” is: • Any U.S.-source payment of interest, dividends and other fixed or determinable annual or periodical gains, profits, and income (“FDAP”); for example bond interest or stock dividends • Gross proceeds from sale of property that is of a type that can produce U.S.-source dividends or interest, for example gross proceeds on the sale of stocks or bonds

9. FATCA: Key Dates

10. Debt vs. Equity is Still With Us… • Trust Preferred Securities • Contingent Convertible Bonds • Caselaw Developments • U.S. View

11. Trust Preferred Securities • Trust preferred securities are in the process of being phased out as Tier 1 regulatory capital as a result of Dodd-Frank and Basel III. • As a result, most trust preferreds are being called or refinanced. • The refinancing, however, has occurred at a much slower pace. • In 2012, $46.6 billion of trust preferreds were called, but only $21.3 billion of new preferred stock was issued.

12. Contingent Convertible Bonds • Barclays Bank PLC as issuer. • $3 billion CoCo (November 2012). • 7.625% ten year notes, holder must transfer for “nil” value to parent if Barclays’ CET1 declines below 7%. • $1 billion CoCo (April 2013). • 7.75% ten year notes (callable after five years), holder must transfer for “nil” value to parent if Barclays’ CET1 declines below 7%. • Tax issues – debt or equity? • Unconditional promise to pay a sum certain? • Treatment in the UK—tax deductible under current law. • Treatment of U.S. holders—equity eligible for preferential “qualified dividend income” treatment.

13. Caselaw Developments • Recent debt v. equity caselaw • PepsiCo Puerto Rico (TC Memo 2012-269). Held: Equity – taxpayer wins. • NAGP (ScottishPower) (TC Memo 2012-172). Held: Debt – taxpayer wins. • Hewlett-Packard (TC Memo 2012-135). Held: Debt – taxpayer loses. • 11-13 factors • Citing Hardman v. United States, 827 F.2d 1409 (9th Cir. 1987) (11 factors); Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972) (13 factors); A.R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970) (11 factors); Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980) (13 factors), etc. • Find out what the law is in your Circuit!

14. U.S. View • Orderly Liquidation Authority—Dodd Frank grants extraordinary powers to FDIC. • Financial institution creditors subject to “bail-in” of their debt. • So in the U.S., rather than replace trust preferred with a new tax deductible instrument (like CoCos), the plan is to make debt more equity-like.

15. Excess Mortgage Servicing REIT • Mortgage Servicing Fee = reasonable fee + “Excess Servicing Spread” • Excess Servicing Spread treated as a coupon strip under Section 1286. • REIT Requirements: • At least 75% of a REIT’s assets must be “real estate assets” • At least 75% of a REIT’s gross income must be “qualifying income.” Includes interest on obligations secured by mortgages on real property or interests in real property

16. Excess Mortgage Servicing REIT • Questions: • Is the Excess Servicing Spread a “real estate asset”? • Is income from the Excess Servicing Spread “qualifying income”? • PLRs 201234006 & 201328018: Yes. Excess servicing spread is a real estate asset and generates qualifying REIT income.

17. Basket Option Contracts • Bank buys portfolio of stocks desired by Fund • Fund buys a two-year option whose value is tied to the portfolio. • Fund controls the contents of the portfolio. • Despite constant turnover in portfolio, Fund continues to hold only one asset, the option.

18. Basket Option Contracts • Desired result: Long-term capital gain rather than short-term trading gain • IRS Memorandum AM 2010-005: • Fund owns the portfolio, must recognize gain and loss from trades in the portfolio • “Particularly aggressive” transaction • Bloomberg article: “Simons Strategy to Shield Profit From Taxes Draws IRS Ire,” July 1, 2013

19. Tax Reform? • Current System for Taxing Derivatives • House Ways & Means Committee Discussion Draft • Mark-to-Market for Derivatives • Accrual of Market Discount • COD on Debt Exchanges • Average Basis • Hearings Held on March 20, 2013

20. Current System for Taxing Derivatives • Current tax treatment of certain financial instruments traded on the various exchanges:

21. Mark-to-Market for Derivatives • Academics have been calling for a mark-to-market system for the taxation of financial instruments for a long time. • Joint Senate Finance – House Ways & Means Committee hearing on December 6, 2011. • JCT Report identifies the five financial instruments: • Stock • Debt • Options • Forwards • Notional Principal Contracts

22. Mark-to-Market for Derivatives • Chairman Dave Camp (R-MI) of the House Ways & Means Committee proposed a mark-to-market system for the taxation of “derivatives” on January 24, 2013. • Press Release: • “The lack of consistent and comprehensive tax policy has also contributed to some corporate scandals and the recent financial crisis that devastated our economy and threatened our standing in the global community. Updating these tax rules to reflect modern developments in financial products will make the code simpler, fairer and more transparent for taxpayers; and it will also help to minimize the potential for abuse that has occurred in the past.” • Subcommittee Hearing: March 20, 2013

23. Mark-to-Market for Derivatives • New Code Sections • IRC Section 485 – Treatment of “derivatives”. • IRC Section 486 – “Derivatives” defined. • Applies to all derivatives held by dealers (who are currently subject to IRC Section 475 with respect to derivatives held as inventory or for sale).

24. Mark-to-Market for Derivatives • Obsolete Code Sections • IRC Section 1234B – Gain or loss on a securities futures contract treated as gain or loss from the sale or exchange of property that has the same character as the underlying property in the hands of the taxpayer. • IRC Section 1236 – Capital gains treatment for securities that are held by dealers for personal investment. • IRC Section 1256 – 60/40 treatment (60% long-term capital gain and 40% short-term capital gain) for certain futures and options contracts.

25. Mark-to-Market for Derivatives • Basic Rule • Mark-to-market – any derivative held at the close of a taxable year is treated as sold for its fair market value on the last business day of such year, and gain or loss would be recognized in such year. • Basis – ongoing adjustments for gain or loss recognized. • Items of Income, Gain, Loss, and Deduction • Treated as ordinary income or loss. • Treated as attributable to a trade or business for purposes of IRC Section 172(d)(4), which limits the non-trade or business deductions of non-corporate taxpayers to non-trade or business income.

26. Mark-to-Market for Derivatives • “Derivative” definition would be broad: • Any evidence of an interest in (or any derivative financial instrument with respect to) stock, partnership interest, beneficial ownership interest in a trust, debt, real property (with certain exceptions), actively traded commodity, currency, and notional principal contract. • Includes any “derivative financial instrument” with respect to any of the above. • Derivative Financial Instrument: any option, forward contract, futures contract, short position, swap, or similar financial instrument. • Includes any “embedded derivative component” in a debt instrument. • Embedded Derivative Component: any term of a debt instrument that affects its cash flow or the value of other payments required by the instrument in a way similar to a derivative. • Does not include stock, straight debt, CPDI or VRDI. • As written would include compensatory options and options on partnership interests.

27. Mark-to-Market for Derivatives • Special Provisions • Mixed Straddles – mark-to-market regime applies to all non-derivative positions that are part of a tax straddle with a derivative. • Terminations / Transfers – mark-to-market regime applies to any termination or transfer of the rights or obligations with respect to a derivative during the taxable year, whether by exercise, settlement, etc. • Fair Market Value • If not readily ascertainable, look to method used in report or statement (i) to shareholders, partners or other persons provided in the applicable Treasury Regulations, or (ii) for credit purposes. • Fair market value of an “embedded derivative component” in a instrument is (i) the fair market value of the instrument with the component over (ii) the fair market value of the instrument without the component.

28. Mark-to-Market for Derivatives • Unanswered Questions • Who will be covered? • Existing derivatives - grandfathered? • Opportunity to opt-in to the regime? • What will be covered? • Mutual funds? • Coordination with IRC Section 1032 • IRC Section 1032: “. . . No gain or loss shall be recognized by a corporation with respect to any lapse or acquisition of an option . . . to buy or sell its stock (including treasury stock).”

29. Structured Notes • 2012 volume of structured products and structured notes • SEC registered offerings of structured products amounted to $65 billion in gross sales. • U.S. is now the third largest market of structured products globally, just behind Italy and Germany. • 548 notes linked to Apple Inc. sold in the U.S., totaling $1.74 billion. • 57% decline in sales of U.S. reverse convertibles.

30. Structured Notes • Tax Treatment • “Bifurcation” of debt instruments for tax purposes abandoned in 1994. • Current accrual for contingent debt instruments, but not for other contingent financial instruments. • Non-debt instruments are subject to the “open-transaction” doctrine – essentially a “wait and see” approach. • SEC Disclosure Requirements • SEC now requires issuers to disclose the “issuer estimated value” of structured notes on the cover page of the offering document. • The estimated value is to be based on the value of the bond element and the derivative element of the structured note separately.

31. Structured Notes • SEC Disclosure Requirements (continued) • Sample disclosure: “The estimated value of your notes at the time the terms of your notes were set on the trade date (as determined by reference to pricing models used by [issuer] and taking into account our credit spreads) was equal to approximately $974 per $1,000 face amount, which is less than the original issue price. The value of your notes at any time will reflect many factors and cannot be predicted; however, the price (not including [issuer]’s customary bid and ask spreads) at which [issuer] would initially buy or sell notes (if it makes a market, which it is not obligated to do) and the value that [issuer] will initially use for account statements and otherwise equals approximately $990 per $1,000 face amount, which exceeds the estimated value of your notes as determined by reference to these models.”

32. Circular 230 To ensure compliance with requirements imposed by the IRS, Morrison & Foerster LLP informs you that, if any advice concerning one or more U.S. Federal tax issues is contained in this communication (including any attachments), such advice is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.