1 / 24

Practising Law Institute Financial Products and Transactions

Practising Law Institute Financial Products and Transactions . Viva Hammer KPMG, LLP -- Washington National Tax Edward Kleinbard USC Law School Stephen R. Larson IRS -- Associate Chief Counsel - FIP December 2011 Los Angeles. Overview of proposed 1256/446 regulations. Background

wilbur
Download Presentation

Practising Law Institute Financial Products and Transactions

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Practising Law InstituteFinancial Products and Transactions Viva Hammer KPMG, LLP -- Washington National Tax Edward Kleinbard USC Law School Stephen R. Larson IRS -- Associate Chief Counsel - FIP December 2011 Los Angeles

  2. Overview of proposed 1256/446 regulations Background • Enactment of Dodd-Frank Act and amendment to section 1256 Broadening scope of “notional principal contract”, other technical changes • Bullet swaps • Credit default swaps • Exotic swaps (weather swaps, longevity swaps) • Portfolio swaps • Futures/scope of section 1256 Effective date

  3. Background • Uncertain application of section 1256 to swaps subject to Dodd-Frank • Section 1256 requires mark-to-market , capital gain/loss for “section 1256 contracts” • Dodd-Frank requires swaps to be cleared through a central counterparty (“clearinghouse”) and traded on regulated exchanges • Last-minute amendment to Dodd-Frank amended section 1256 to clarify that certain swaps and “similar agreements” not included in definition of section 1256 contract

  4. Notional Principal Contract - definition • New proposed regs provide that Dodd-Frank amendment covers any NPC or option on NPC • Proposed regs expand definition of NPC • Taxation of NPCs provided for under prior regs • New proposed regs are proposed to be effective for contracts entered into on or after final regulations are published • Public statements by IRS that taxpayers need not adopt rules of proposed regs before finalized e.g., CDS currently treated by some as options

  5. Bullet swaps • NPC definition requires at least one party to make more than one payment • “Payment” is defined in proposed regs to include “an amount that is fixed on one date and paid . . . on a later date” • “Bullet swaps” — with a single payment at maturity calculated as accumulation of amounts fixed during its term — treated as an NPC • Forward rate agreement is not a NPC • Forward contract on equity with interim accruals of dividend-and interest-equivalent amounts is an NPC

  6. Bullet swaps • “Payment” definition is novel - inconsistent with market practice and conventional meaning of term “payment” • Potential adverse consequences for individual investors, because of miscellaneous itemized deduction rules • Potential timing and character consequences for all taxpayers • Possible effects on exchange-traded notes and other structured notes • Possible effects on futures contracts

  7. Bullet swaps • Preamble: Questions have arisen as to the proper interpretation of the NPC definition requiring “payment of amounts” • Implies that there is uncertainty under current law on NPC definition. • Possible “uncertainty” is whether multiple payments by one party are required. • Possible “uncertainty” is as to proper treatment of bullet swaps, source of uncertainty obscure. • Meaning of term “payment” seems very clear; cf the OID regulations • 2004 proposed regulations contain several definitions consistent with treating bullet swaps as non-NPCs

  8. Credit default swaps • Uncertainty whether CDS should be: NPC, option, insurance, guarantee • Proposed regs CDS are NPCs; no definition of “credit default swap” • Options: no accrual, capital G/L, NPCs: current accrual, ordinary Y/Exp • Application of NPC timing/character rules to CDS unclear • How to amortize upfront and settlement payments over life of CDS? • Potential recharacterization of payments as interest • Anticipated reproposed 2004 regulations will hopefully address these issues and more generally interaction between 2011 proposed regs and NPC timing rules

  9. Exotic swaps • Proposed regs expand NPCs to include swaps on objective non-financial indices, if the index is not front- or back-loaded. E.g., weather swaps • Why limit non-financial indices to non-front- or back-loaded indices? • OID rules can handle front- and back-loading and NPC rules already do for caps and floors • Many longevity swaps could be back-loaded

  10. Effective Date issues • Proposed regs proposed to be effective for contracts entered into on or after final regulations are published • How does Dodd-Frank exemption operate before finalization of proposed regs?

  11. Open Issues What is a “payment” for purposes of the proposed regulations? • What if the expected payment is zero, is that a fixed payment? • For example, a contract that provides for a settlement payment referenced to the appreciation or depreciation of a specified number of shares of common stock, adjusted for actual dividends paid during the term of the contract, is treated as a contract with more than one payment with respect to that leg of the contract • What if it is a non-dividend paying stock – does it still provide for 2 or more payments? • Does an equity forward that contains an adjustment provision for extraordinary dividends cause the plain vanilla equity contract to be characterized as an NPC?

  12. Open Issues • If the proposed regulations apply to CDS and bullet swaps, how should the “payments” be treated for tax purposes? • applicability of 2004 proposed NPC regulations • 4 approaches to accounting for contingent swaps as discussed in Notice 2001-44

  13. Open Issues • Clarification as to whether the proposed regulations apply to all CDS or just CDS that are not otherwise classified for tax purposes as options or guarantees • If new proposed regulations apply to bullet swaps or CDS that are not currently treated as NPCs, how does a taxpayer change its method of accounting? • Clarification surrounding definition of “non-financial index” • Specifically, when can non-financial indices be reasonably expected to front-load or back-load payments accruing under the contract?

  14. Pritired 1 LLC v. United States Principal (U.S.) CitiBank (U.S.) French Banks (Foreign) $930M $150M $150M $475M in 1% Convertible Notes and $455M in Class A Shares $300M FTCs Pritired (U.S.) $9M of Class B shares and $291 of Perpetual Certificates SAS (Foreign)

  15. Pritired The Basic Economic Transaction: U.S. partnership enters into co-investment transaction with a tax-indifferent foreign investor. Through the transaction, foreign investor is able to borrow money at below market rates. U.S. investor receives the benefit of claiming FTCs on the foreign taxes paid on entire combined investment pool.  • In essence, the U.S. partnerships gives foreign investor a loan in exchange for a small portion of income and all FTCs. The Actual Transaction (simplified): • Taxpayers contributed $300M cash to newly formed Pritired 1 LLC (“Pritired”), which had elected to be treated as a partnership for Federal income tax purposes • French Banks created and funded 2 French entities (“the SAS”) with $930M. In exchange for the $930M, SAS issued $475M in 1% Convertible Notes and $455M in Class A Shares to the French Banks. • Pritired transferred the entire $300M to the SAS. In exchange, the SAS issued $9M of Class B shares and $291 of Perpetual Certificates to Pritiered. • When added to the $930M from the French Banks, SAS had $1.23B. Thus, the transaction essentially provided $300M of new funds to the French Banks.

  16. Pritired Notice of Final Partnership Administrative Adjustment (FPAA) • The IRS alleged the transaction was an abusive arrangement and its FTCs were disallowed for 5 reasons: • The B shares and PCs were considered to be debt instruments and not equity • The transaction was a loan because Pritiered was not a partner in the SAS • Pursuant to the anti-abuse rule in section 1.701-2, the transaction was re-characterized as a loan because the B shares and PCs were debt instruments • The special allocation of FTCs to Pritiered lacks economic effect • The transaction generating the FTCs lacks economic substance

  17. Pritired District Court’s Analysis of the FPAA #1 Whether the transaction should be characterized as a loan • The court found the Class B Shares and PCs had attributes more closely related to debt and that the substance of the transaction was a loan. • The court’s debt/equity analysis focused on characterization, market risk, credit risk, and, voting rights. #2 Whether the transaction lacks economic substance • Applying the 8th Circuit’s conjunctive economic substance test, the court determined that taxpayer had no realistic opportunity to earn a profit independent of the FTCs, and did not expect to earn a meaningful return without the foreign tax credits. • The court rejected taxpayer’s argument that it should be permitted to rely on examples in Notice 98-5, which considered as a factor in determining whether an arrangement was abusive the expected economic profit from the arrangement when compared to the FTCs generated.

  18. Pritired District Court’s Analysis of the FPAA #3 Whether the transaction violates the anti-abuse rule under of section 1.701-2 • The court held that the transaction did not have a substantial business purpose because it was "designed to transfer and shift the payment of French taxes to instruments that otherwise have a low and undesirable return."  #4 Whether the transaction lacks substantial economic effect pursuant to section 1.704-1(b)(2) • The court held that even if the transaction constituted a bona fide partnership, the special allocation of French tax expense and net income lacked substantial economic effect and was not consistent with the partners’ interests in the partnership.

  19. Samueli v. Commissioner Background — Black Letter Law Observations: • If I own a bond with OID, I accrue interest income. • If I lend a security to another party (e.g., for that person to sell in a “short sale”), I am no longer the tax owner of the security (although I am in the same economic position). • If I lend a security in a transaction that qualifies under section 1058, my original basis in the security will carry over onto the security that is ultimately returned to me. Furthermore, my holding period in the security is not interrupted.

  20. Samueli The Basic Economic Transaction: Cash-basis taxpayer (Samueli) buys fixed-yield zero coupon bond, with purchase price principally financed through floating rate debt. This is a bet that short-term rates will go down. • Taxpayer would be required to accrue OID, but gets deductions for interest only when paid. The Actual Transaction (simplified): • Taxpayer buys zero coupon bond for $80, financed with LIBOR-rate margin loan. • Taxpayer lends bond back to broker, in exchange for cash collateral. Securities loan is unusually long-term (450 days) and is scheduled to terminate shortly before bond matures. • Taxpayer repays the margin loan with the cash (so cash is “circling”). • Taxpayer pays LIBOR on the cash collateral (so no change to funding costs). • As an economic matter, the bond will accrete in value over the term of the securities loan. Taxpayer takes position he is not required to accrue OID because he no longer owns the bond. • At maturity of stock loan, broker is obligated to return the bond to taxpayer. But instead, broker buys the bond, for $97.

  21. Samueli — The Opposing Positions TP position #1: • TP has $17 of LTCG (from the purchase of the bond at $80 and disposition at $97). • Section 1058 operates to ensure taxpayer takes a carryover basis of $80 in bond when it is returned. • Section 1058 also allows TP’s holding period to continue un-interrupted. • TP also has $16 of ordinary deduction (from the delayed payment of the fee for the collateral) IRS Counterargument: • TP purchased bond on day 1 and immediately sold it to the bank on the same day. • In other words, TP did not lend the bond to the bank in a non-recognition transaction governed by section 1058. On day 1, TP has basis of $80, and sold the bond for the bank’s obligation worth $80 — realization and recognition event, but no gain/loss simply as a result of the values. • Instead, TP has entered into forward contract to buy bond at maturity (end of year 1.75). Ultimately, TP buys bond at $96 on that date and sells it for $97 that same day — resulting in $1 of Short-term CG. TP position #2: • Even if the day 1 transaction is not a securities loan, the resulting forward contract was held for more than a year. It was cash-settled. Therefore, the $1 of profit is Long-term CG.

  22. Samueli – The Tax Issues • #1. Was the day 1 transaction, in fact, a valid securities loan under section 1058? • In order for arrangement to qualify for non-recognition, the transferor must be in the same economic position. • The agreement by which the securities are lent must “not reduce the . . . opportunity for gain of the transferor of the securities in the securities transferred.” Section 1058(b)(3). • TP could not call back the securities for 1.75 years. 9th Circuit Court holds: • “During this period, TP could not have taken advantage of a short-lived spike in the market value of the securities . . . Common sense compels the conclusion that this reduced the opportunity for gain that a normal owner of the securities would have enjoyed.” • “our conclusion that the transaction . . . reduced TP’s opportunity for gain does not necessarily imply a conclusion that a securities loan must be terminable upon demand to satisfy the requirement of section 1058(b)(3).” • What of shorter “term loans” of securities? 180, 90, 60 days? Note: court’s emphasis on purpose of section 1058, and that it is exclusive avenue for non-recognition.

  23. Samueli – The Tax Issues • #2. Assuming a sale occurs on day 1 (not section 1058 transaction), does the cash settlement of the arrangement generate long term capital gain? IRS argues that cash-settlement of the contract at maturity does not reflect a cancellation or termination of the contract under section 1234A. Instead, it merely reflects the fulfillment of the contract. If securities had actually been delivered, TP would have been purchased for $96 and sold at $97 (with short-term holding period). It is not appropriate to “mark-to-market” the forward contract (and recognize a $1 LTCG) — rather, the contract must be treated as having been fulfilled/performed. *9th Circuit Court agrees. Note: The IRS & court position is directly contrary to analysis in CCA 201104031 (re: closing forward with borrowed shares)

  24. Contact Viva Hammer KPMG LLP -- Washington National Tax vhammer@Kpmg.com (202) 412-9798 Edward Kleinbard USC Law School ekleinbard@law.usc.edu  (213) 740-4582 Stephen Larson Internal Revenue Service -- Financial Instruments and Products Stephen.Larson@irscounsel.treas.gov (202) 622-3900

More Related