Current Developments Involving Tax-Advantaged Financial Products. March 14, William Skinner, Esq., Fenwick & West LLP

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1 Current Developments Involving Tax-Advantaged Financial Products March 14, 2012 William Skinner, Esq., Fenwick & West LLP This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representative or warranty (expressed or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, Fenwick & West LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice in this communication is not intended or written by Fenwick & West LLP to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing, or recommending to another party any transaction or matter addressed herein. A9304/00101/DOCS/

2 TABLE OF CONTENTS Page 1. Introduction...1 (a) Joint Committee Report on Reform of Financial Products Taxation Variable Prepaid Forward Contracts (VPFCs) & Stock Monetization Transactions...1 (a) Introduction...1 (b) Section (c) Variable Prepaid Forward Contracts Rev. Rul (d) Recent developments including VPFCs...4 (e) Holding Period Issues (m) Temporary Regulations Withholding on Equity Derivatives...8 (a) Definition of Notional Principal Contracts (NPCs)...8 (b) Genesis of 871(m)...9 (c) 871(m) Specified NPCs...10 (d) Temporary and Proposed Regulations Deferral of Income on Stock Ownership Exchange-Traded Notes (ETNs)...11 (a) What is an ETN?...11 (b) Intended Tax Treatment of ETNs under Current Law...11 (c) Authorities and Proposed Law Changes regarding ETNs...13 (d) Chief Counsel Advice Memorandum No Contingent Convertible Debt and Call-Spread Convertible Debt...16 (a) Plain Vanilla Convertible Debt...16 (b) Contingent Convertible Debt Rev. Rul (c) Call-Spread Convertibles (IRS Advice Memo ) i-

3 1. Introduction (a) Joint Committee Report on Reform of Financial Products Taxation (JCX-56-11) (Dec. 2011) noted two issues with financial products taxation: Tax rules depend on the nature of the instrument, rather than economics of transaction; thus, economically similar transactions can be taxed differently. Ability to combine existing instruments to create a synthetic position similar in effect to another instrument taxed differently enhances flexibility and creates challenges for existing rules. (1) E.g., put-call parity makes it possible to construct and deconstruct economically equivalent positions using different financial instruments subject to different tax regimes. (2) As between economically equivalent instruments, there is no underlying substance that governs over other characterizations. 2. Variable Prepaid Forward Contracts (VPFCs) & Stock Monetization Transactions. (a) Introduction. (iii) (iv) Object of transition is to obtain liquidity and reduce risk of ownership of appreciated stock without recognizing immediate gain. Compare margin loan secured by the shares obtain cash tax-free (as a loan), but retain risk of depreciation of the stock. Compare actual sale of shares obtain liquidity and reduce risk of depreciation in the stock, but pay immediate tax under Consider possible interest among new shareholders in an IPO (b) Section Imposes tax if the taxpayer makes a constructive sale of an appreciated financial position. Enacted in 1997 in response to Estee Lauder short against the box transaction (1) After Lauder IPO, father holding appreciated shares borrows other shares and sells short. Pledges appreciated shares to secure the obligation to repay shares sold short. A9304/00101/DOCS/

4 (2) Eliminates risk and obtains cash tax-free until short sale is closed by delivery of shares. (Short-sale is viewed as an open transaction). (3) Short sale remains open indefinitely until appreciated shares pass through estate with a step-up in basis under Then shortsale is closed with high basis shares, no gain or loss recognized. (iii) (iv) Rev. Rul IRS respected a short sale as an open transaction despite the fact that the taxpayer held identical securities with its broker that secure its obligations to cover the short sale. 1 Appreciated financial position broadly defined to cover stock, certain debt instruments, 2 or a partnership interest, or derivative positions with respect to these items such as options, futures, short sales, etc. (1) Property does not need to be publicly or actively traded; only appreciated in value. (2) Applies to an interest in a fixed investment trust that is actively traded unless the trust solely holds certain fixed-rate debt instruments. (v) Constructive sale statute lists several specific types of transactions and also a residual catch-all of risk reduction transactions: (1) Short sale (2) Offsetting NPC (total return equity swap) (3) Futures or forward contract to deliver the shares a. 1259(d)(1) defines forward contract to mean substantially fixed number of shares at a substantially fixed price. This excludes Variable Prepaid Forward Contracts ( VPFCs ) from automatically effecting a constructive sale. (4) Constructive sale may occur where TP acquires property to cover a future / forward or short sale that is itself an appreciated financial position (5) To the extent provided in yet unissued regulations, one or more other transactions that have substantially the same effect as one 1 See also Rev. Rul (entering into a second short sale does not close first short sale or cause pre short-against-the-box to lose its status as grandfathered) does not apply to straight debt instruments that are not convertible into equity, have a fixed principal amount, and require interest to be paid annually at a fixed interest rate. See 1259(b)(2)(A). 2

5 of the preceding transactions may also be treated as constructive sales. a. Per the legislative history, rule is intended to apply where the transactions eliminate substantially all of the taxpayer s risk of loss and opportunity for income and gain. IRS supposed to consider economic and financial facts, such as volatility in making this determination. Relevant factors also include exercise period of option and spread between option price and FMV, as well as whether the taxpayer retains the rights to vote the stock and receive dividends. b. Examples i. Buying a put at the money is not a constructive sale because taxpayer retains the upside ii. iii. Buying a put with a exercise price significantly above the money may be a constructive sale if it is unlikely that the stock will appreciate above the strike price during the exercise period (e.g., $120 strike price put on $100 stock) Equity collar share is at $100, and taxpayer writes a call at $110 and buys a put at $95. The IRS and Treasury are directed to write regulations, on a prospective basis, concerning the circumstances in which a collar transfers sufficient risk of gain and loss to be a constructive sale. (c) Variable Prepaid Forward Contracts Rev. Rul Holding did not apply to a transaction where appreciated stock was worth $20 / share, and the taxpayer contracted with a bank and received $z of cash up front in exchange for an obligation to deliver a variable number of shares at settlement (a Variable Prepaid Forward Contract or VPFC): (1) 100 shares if the FMV of the stock on delivery was $20 or less (2) If the shares are worth between $20 and $25 each, a number of shares worth $1000 (3) If the shares are worth $25 or more, 80 shares. 3

6 (iii) The stock was pledged with a third party trustee to secure the obligation. However, the shareholder retained the right to vote the shares and receive dividends. The shareholder was free to substitute cash with an equivalent FMV to the shares at settlement and receive back the pledged shares. The shareholder was not economically compelled to deliver the pledged shares. (iv) Analysis (1) 1001 under case law, the delivery of shares was not an actual sale, provided that the shareholder retained incidents of ownership (voting rights and dividends), control (no stock loan to the bank, or pledge to the VPFC bank), and was expected to have sufficient resources to have a meaningful choice as to whether to settle the VPFC with the pledged shares or money / other property. (2) 1259 Because the number of shares varied significantly (between 80 and 100), the VPFC is not a forward contract under 1259(d)(1), and therefore, not a constructive sale under (d) Recent developments. (iii) VPFC coupled with Securities Loan. Investment bank counterparty will hedge exposure and pass on the hedging costs to the taxpayer. This results in significant fees / transaction costs to the taxpayer. However, transaction costs could be reduced if the taxpayer pledged the shares with the bank and the bank sold the pledged shares short (i.e., a securities loan), so that it is naturally hedged in the transaction. TAM & General Legal Advice Memorandum In a position that would play out in Anschutz and related cases, the IRS limited Rev. Rul to its facts and ruled that, case where the pledged shares are lent to the counterparty, such that the bank had possession and unfettered use of the shares underlying the forward contract, 1001 would apply to the transaction on day 1. No need to reach 1259 because there is an actual sale. Anschutz v. Commissioner, U.S.T.C. 50,117 (10 th Cir. 2012), aff g 135 T.C. No. 5. Philip Anschutz entered into a series of VPFCs, coupled with a share loan to the bank (DLJ) that allowed DLJ the unrestricted ability to sell the pledged shares. The pricing of the VPFC appeared not to leave any risk of downside movements with Anschutz although this by itself should not have been fatal based on the legislative history of Under an analysis of the benefits and burdens, the Tenth Circuit upheld the Tax Court s finding of a current sale. Key factors: 4

7 (1) The share loan transferred legal title and power to dispose of the shares to DLJ (2) The taxpayer had effectively cashed out of the investment. The share loan and VPFC were non-recourse to Anschutz and thus shifted divested Anschutz of all risk of declines in value of the shares. (3) DLJ had possession and control of the pledged shares. (4) Under the terms of the contracts, Anschutz s retained upside appreciation was somewhat diminished (only 50% of upside within a specified range). (5) Anschutz transferred voting rights and some dividend rights. The fact that DLJ made dividend equivalent payments to Anschutz under the securities loan was not dispositive. The court did not need to reach 1259 because it viewed the transaction as a current sale under See also Calloway, 135 T.C. 26 (2010). (iv) Attempt to use short sale to defer gain on an in-the-money VPFC. IRS Legal Memo ( ILM ) (Apr. 2011). (1) Background PLR Corporate Taxpayer entered into a series of variable forward contracts (not prepaid) and pledged shares to secure its delivery obligation. Bank did not have the right to sell, assign, or re-hypothecate the shares. Taxpayer was free to deliver other shares besides those pledged. At maturity, Taxpayer borrowed shares in a separate securities lending agreement and delivered the borrowed shares to close the forward contracts, receiving cash at that time. Holdings: a. The delivery of borrowed shares under the forward contracts was treated as a normal short sale under The taxpayer did not recognize its gain on the forward contract. b. However, the short sale caused the taxpayer to recognize gain on its pledged Existing Shares under 1259 (i.e., this was a short-against-the-box). (2) Taxpayer in the ILM entered essentially the same transaction as the PLR, except that the VFCs were prepaid. As in the PLR and unlike in Anschutz, the taxpayer avoided granting the bank the ability to re-hypothecate the shares. 5

8 (3) Taxpayer s Treatment. The taxpayer treated the VPFCs as remaining open, and the short-sale as triggering a constructive sale of the underlying pledged shares. (4) (5) Chief Counsel s Position. The settlement of the VPFC with borrowed shares was a 1001 event of the VPFC itself. Alternatively, the amount of cash received upfront in the VPFC is included in the proceeds of the constructive sale of the underlying pledged shares under Why this issue arose. The difference between the taxpayer s and Chief Counsel s position turns on the amount of gain. To the extent the floor price on the VPFC exceeded the FMV of the shares at maturity, there was a gain in the contract not reflected in the gain recognized on the shares under 1259(a). By contrast, on other facts, where the FMV of the shares exceeds the cap price on the VPFC, it would be better to treat the VFPC as closed by the short sale than to trigger a constructive sale of the underlying shares. The analysis of Chief Counsel on the merits seems questionable. In either the VFPC or regular VFC, the end result is a delivery of the shares and receipt of the agreed-upon cash price in the Forward Contract. The timing of the receipt of a fixed amount of cash does not affect the taxpayer s benefits and burdens of ownership, or whether the contract should be viewed as closed. The ILM appears to be a results-driven, heads-i-win, tails-you-lose analysis. More pragmatically, the ILM illustrates the need for caution in relying on a PLR, which the IRS may refuse to apply on slightly different facts or simply refuse to apply on identical facts where the PLR leads to a more taxpayer-friendly result than anticipated. (v) Takeaways from new authorities. VPFCs should still be viable, but taxpayers need to be careful not to vest possession or control over the shares in the counterparty. (e) Holding Period Issues: Assume shareholder acquires shares and enters into a transaction described in Rev. Rul within one year of exercise (i.e., before the shares have a long-term holding period). When VPFC settles, the pledged shares (or other shares) are transferred to the counterparty at a gain. Certain rules can reset or toll the holding period during the VPFC term, resulting in a short-term capital gain. Straddle rules ( 1092). 6

9 (1) Only applies if the stock is actively traded on an established financial market. 1092(d)(3)(A). This includes NASDAQ and other public companies. Also includes stock traded on an interdealer market where the stock is listed on a quotation medium. (2) VPFC or collar generally gives rise to a straddle under 1092(c)(2). a. If holding period in stock making up the straddle is a short-term holding period at time straddle is created, then under Reg (b)-2T, the taxpayer s holding period is reset to zero and suspended during the period the straddle is outstanding. b. Any interest incurred in connection with the VPFC then is capitalized into the basis of the stock. See 263(g). c. Absent regulations, can a straddle identification limit the holding period reset only to the identified shares, and allow long-term holding period to accrue on other shares? I.e., does an identification solve an unbalanced straddle problem? For example, 1092(a)(2) authorizes the use of an identified straddle to link the two offsetting positions and capitalize any realized loss into the basis of the open gain position. 1092(c)(2)(B) authorizes the IRS to write regulations to identify which positions make up a straddle. In PLR , the IRS ruled that, even absent regulations, under 1012 s share identification rules, a taxpayer could identify which shares were offsetting with respect to a costless collar. (iii) 1233 short sale rules. a. Precursor to 1092 with similar effects for stock that is not actively traded on an established securities market. b. Short sale, securities futures contracts and put options are treated as short sale by statute. Is a VPFC treated as an option to sell for 1233 purposes? c. Under 1233(b), a holding period that is not long term on the date of the short sale of the property is reset to zero and tolled during the period the short sale remains open. 7

10 d. 1233(c) exception for married puts entered on the same date the property is acquired (m) Temporary Regulations Withholding on Equity Derivatives. (a) Definition of Notional Principal Contracts (NPCs). (iii) (iv) (v) Reg s definition of a notional principal contract as any agreement to pay amounts calculated by reference to a specified index with respect to a notional principal amount. Notional principal amount = any stated sum that is used to measure the parties rights and obligations under the NPC. Specified index = any fixed rate, variable rate, or other objectively determinable financial information that is not unique to either one of the parties or within one of the parties control. Example. Party A contracts with Bank to make a notional investment of $100,000 in Exxon shares, with annual payments determined by reference to the trading value of those shares, plus any dividends that may be paid. Party A agrees to pay Bank an amount equal to the Federal prime rate + 3% on $100,000. In addition, if Exxon shares decline in value at any time, Party A must make payments to Bank equal to decline in value. Consequences of NPC. (1) Bank will buy Exxon shares and mark both the NPC and the shares to market under 475. Economically, and for tax purposes, Bank would generally earn net income equal to a spread that compensates for its intermediary role. (2) Party A will have upside / downside with respect to $100,000 of shares in exchange for paying interest on $100,000. Effect is similar to borrowing on margin to buy Exxon shares. There may be advantages in that any net payments on the NPC are not interest and, therefore, may not be subject to limitations on deductibility of investment interest. 3 (3) If Party A is a foreign investor, Reg (b) would generally provide that Party A s income from the NPC is foreign source. As 3 See FSA (for purposes of 265, net LIBOR swap payments on a fixed-for-floating interest rate swap were not interest). 8

11 FSI, no withholding tax would apply to the payments, whether attributable to gains or dividends on the underlying shares. 4 (4) Compare effect if Party A borrowed a margin loan and purchased $100,000 of actual Exxon shares. Dividends would be U.S.-source FDAP. Interest expense to carry the shares would not reduce withholding tax because deductions are not allowed under 871(a) and 881(a). (5) Compare Compaq / IES transaction. US taxpayer acquired ownership of naked dividend income stream so as to capture foreign tax credit associated with receipt of dividend income stripped from underlying ownership of the stock. (b) Genesis of 871(m). Levin Report on Dividend Withholding Tax Abuse (Sept. 2008). (1) Uncovered widespread avoidance of dividend withholding tax marketed by major investment banks as dividend enhancement transactions. (2) Example of swap avoidance transaction (Microsoft special dividend). a. Hedge Fund owns Microsoft shares shortly before record date on an extraordinary dividend. Hedge Fund sells shares to Bank. b. Hedge Fund enters into a long total return swap on Microsoft with Bank. c. After payment of extraordinary dividend, Hedge Fund repurchases shares from Bank at pre-arranged ex-record date price equal to swap termination price. (3) Other transactions designed to take advantage of withholding tax calculation for substitute dividend payments in Notice IRS Response in Jan Industry Directive. (1) Identified audit rules for challenging above transactions under general tax principles (i.e., Hedge Fund remained tax owner of stock). 4 See also TD 8491 (1993) (requesting comment on whether NPCs tied to a specific stock should be subject to a different sourcing rule than Reg ); Rev. Rul (holding that NPC with respect to a broad-based US real property index is not a real property interest subject to FIRPTA). 9

12 (2) Cases in which repurchase was from a Foreign Affiliate or Third Party would be scrutinized to see if part of a pre-arranged transaction. (3) Fully synthetic case where Hedge Fund never owned the underlying stock generally not abusive and covered by plain language of Reg (c) 871(m) Specified NPCs. Effective 180 days after enactment in March 2010, treats dividend equivalent payments on specified NPCs as FDAP income subject to withholding. The statute also contains a nuclear option that treats all NPCs over U.S. equities as specified NPCs as of Dec. 31, 2012, unless the IRS acts to identify which NPCs should be subject to 871(m). (1) Dividend equivalent payment includes the gross amount of the swap payment determined by reference to a dividend under the stock (2) Cannot net against LIBOR-based payment back no deduction for investment interest under 871(a) and 881(a). (iii) Specified NPCs include any of the following (1) As part of entering the NPC, the long party transfers the underlying stock to the short party; (2) As part of terminating the NPC, the short party transfers the underlying stock to the long party; (3) The underlying security is not regularly traded; (4) The short party posts the underlying security with the long party as part of the transaction; (5) Other transactions identified in regulations. (d) Temporary and Proposed Regulations. Effective through Jan. 2015, the IRS issued temporary regulations ( T) that essentially limit the categories of specified NPCs to those expressly described in the statute. Prop. Reg : Once effective, this would provide for a broader list of specified NPCs. Important additions: 10

13 (1) NPCs where the long party is in the market with respect to the underlying stock on the same day that the NPC is entered or terminated, or these events are terminated. The long party does not need to cross in or cross out with the short party or an affiliate to run afoul of this rule. (2) All NPCs with duration of 90 days or less. (3) NPC is entered on or after the announcement of a special dividend on the underlying stock. (4) NPC relates to a large percentage of the trading volume in the underlying security. 4. Deferral of Income on Stock Ownership Exchange-Traded Notes (ETNs). (a) What is an ETN? (iii) (iv) Investor purchases an investment contract that provides for a lump-sum payment at maturity equal to the value of an underlying security or commodity or index (e.g., ETNs Russell 2000 Index). Generally, long maturity date, e.g., 30 years. No cash payment to the investor until maturity, although ETN is traded and can be liquidated through a sale at any time. Value at maturity may reflect the price of the underlying index, or may be increased to reflect total return on ownership of the index (i.e., dividends are reinvested). Naked contractual obligation of the bank not a collective trust fund, and bank does not post underlying securities as collateral. (1) Difference in contractual rights became important in 2008 crash (e.g., Lehman bankruptcy). (b) Intended Tax Treatment of ETNs under Current Law. Per the ipath prospectus, ETNs are intended to be treated as prepaid forward contracts. This has the following Federal income tax consequences: (1) Holder does not recognize income until redemption or sale. (2) Sale or settlement of the contract is capital gain or loss (see 1234A) (3) Source of income is residence of the investor under 865(a). 11

14 (4) Interim sales of securities making up the underlying index (e.g., bank s adjusting the index) or receipt of dividends does not affect the investor. (5) Issuer s obligation on maturity does not accrue OID, but issuer does not care because it holds contractual obligation and underlying securities as a 475 dealer. Alternative tax treatments disclosed as risk factors: (1) Contingent payment debt instrument (CPDI). a. Requires holder to accrue interest income over the life of the note b. Issuer receives an interest deduction c. Taints holder s income on sale or exchange of the note as ordinary income d. But treatment is not compelling because repayment at maturity is entirely contingent on the value of the indexed security at maturity i.e., can a debt instrument exist where there is no fixed principal amount at maturity? (2) Direct ownership of indexed securities, with bank as agent / trustee. a. Holder includes dividend income on securities. b. Sales by bank of indexed securities trigger gain or loss to holder, based on bank s holding period. c. Character looks through to underlying assets. d. But treatment not compelling because bank has not segregated any assets to secure its payment obligations under ETNs and ETN holders are passive market investors with no control over bank s decision to buy or sell securities. In publicly traded ETN, bank may not even know the identity of the holders of the ETN at any given time. (3) Possible application of 871(m). a. Typical ETN probably not a specified NPC under Temp. Reg T. 12

15 b. However, after Dec. 31, 2012, ETNs may be affected by Prop. Reg in certain cases. (4) Section 1260 Constructive Ownership (flipside of 1259). a. Designed to prevent character conversion and deferral of income where NPCs, forward contracts, and other constructive ownership transactions are used to obtain exposure to certain financial assets. b. Does not apply to ETNs because statute only applies to partnership interests and other equity interests in passthrough entities. c. Regulatory authority to apply 1260 to debt instruments or stock has not been exercised. (c) Authorities and Proposed Law Changes regarding ETNs. Rev. Rul Characterizes a specific type of currency-linked ETN 5 as a foreign currency denominated debt, rather than a forward contract, with the results that: (1) Income or loss attributable to currency movements is ordinary, not capital. (2) Interest income must be accrued on the note. At the same time that Rev. Rul was issued, the IRS published Notice requesting comments for guidance on ETNs generally. This seems to confirm that Rev. Rul was not intended to disturb the treatment of ETNs other than currency-linked ETNs. (iii) Neal Bill (H.R (Dec. 2007)). (1) Proposed legislation to require current accrual of income on ETNs and other prepaid derivative contracts. (2) Accrual amount is the federal short-term AFR, or if notional amounts are credited to the ETN, the amount credited to the ETN during the year. (3) Accruals are treated as ordinary interest income. Presumably this treatment would also apply for purposes of 871 and Note-holder invests $100 in a right to receive at maturity the spot value of $100 in Euros ( 75), plus a rate of return that reflects interest rates and the market movements in 75 in dollars between initiation and maturity. 13

16 (4) If the contract is exchange-traded, accruals included in income a year cannot exceed the change in value of the instrument in a year, although any accrual capped by FMV in one year will carry over to the following year and taint future appreciation as current, ordinary income. (5) In short, the Neal Bill would conform the treatment of ETNs to debt instruments taxable under the OID rules. (iv) NPC Proposed Regulations (REG , 9/16/2011). (1) Effect on ETNs. IRS proposed regulations expanding the definition of a notional principal contract may have the effect of requiring current accrual of income on ETNs, by treating these contracts as NPCs subject to the ratable inclusion rules of Reg (2) Changes in Definition of NPC. a. Reg (c)(1) defines an NPC as a contract that provides for the payment of amounts by one party to another at specified intervals... in exchange for specified consideration or a promise to pay similar amounts. b. Current rule thus requires one of the parties to pay multiple amounts at intervals to the other party. c. Prop. Reg (c)(1) changes definition to require one party to make two or more payments to the counterparty. i. Importantly, payment is defined as any fixing of an amount on one date that is taken into account or paid on a later date. ii. iii. Thus, a single contract can provide for multiple payments even if no cash is paid until closing. Example Targeted at ETNs? In 2012, A enters a long equity return contract with B that entitles A, at maturity on Dec. 31, 2013 to receive the appreciation on XYZ stock. If XYZ pays dividends during the term, the amount payable at maturity is adjusted. In exchange B receives a payment calculated based on 3-month LIBOR, and a payment equal to any depreciation in the value of XYZ stock. 14

17 iv. Each leg has multiple payments each adjustment to the amounts due for a dividend is a payment (i.e., fixing of an amount due). Similarly, each adjustment to the amount due to B for LIBOR-based is also a separate payment. Therefore, the contract is subject to Reg , rather than being a forward contract or futures contract. v. Commentators have suggested that the key facts leading to the existence of multiple payments is that the adjustment is for actual dividends, as opposed to periodic adjustments for a fixed dividend rate. See News Analysis: The Ramifications of the Expanded NPC Definition, 2012 TNT 14-4; Anthony Tuths, Fundamental Tax Reform of Derivatives, 2012 TNT (Jan. 24, 2012). vi. In any event, if this proposed regulation is finalized, it would seem to apply to many ETNs and require current accrual of ordinary income. (d) Chief Counsel Advice Memorandum No Facts. Hedge Fund entered into an option contract over a basket of securities held by Foreign Bank. The securities had initial FMV of $10x Fund paid $1x and Bank paid $9x. On exercise of the option, Hedge Fund was entitled to receive $10x - $1x Fee +/- any changes in the value of the securities in the basket. If the securities declined by $1x, the contract knocked out and the Fund was required to exercise the option. (iii) (iv) (v) The Fund s GP retained management rights over the basket, and to execute trades, etc. The Fund was required to reduce risk in the basket if the value of the securities began to approach the $9x floor that invoked the knock-out provision. Desired tax treatment. Characterization of the basket contract as an option that allowed the Fund (1) to avoid realizing income or loss on trades effected during the contract s maturity date and (2) to convert shortterm capital gains on trades and ordinary income into long-term capital gain on settlement of the option. See IRS Analysis. The basket contract was not an option, but in substance was direct tax ownership of the basket of securities by the Fund. The conclusion was reached because the Fund had the benefits and burdens of 15

18 ownership, and through its management rights, had control and power of disposition of the securities in the account making up the basket. (vi) Compare to an ETN. The account in the GLAM can be thought of as a customized ETN, with control rights. Based on common law principles, the IRS asserted that the control and knock-out rights caused the Fund to be the owner of the securities underlying the contract. 5. Contingent Convertible Debt and Call-Spread Convertible Debt. (a) Plain Vanilla Convertible Debt. Reasons for Convertible Debt. (1) Allows debt financing at a lower yield (less interest expense) by offering the investor upside participation in equity. (2) At the same, earnings per share (EPS) is not diluted to reflect issuance of equity until conversion occurs. Tax Treatment of Straight Convertibles. (1) Do not break out the value of the conversion feature for OID purposes i.e., unlike a warrant, the conversion right does not give rise to OID in the debt. See Treas. Reg (j); Chock Full o Nuts, Inc. v. Commissioner, 453 F.2d 300 (2d Cir. 1971). (2) Conversion generally is tax-free to the holder and the issuer, without regard to whether the debt constitutes a security eligible for recapitalization treatment under 368(a)(1)(E). See Rev. Rul Exceptions: a. Constructive payment of accrued, but unpaid interest is ordinary income if interest not already included in income by holder. b. COD income to issuer if FMV of stock is less than the amount of the debt on conversion. (3) Interest is deductible under normally applicable rules. Certain specific issues can affect deductibility: a. 163(l) (debt payable in equity) does not apply, unless conversion price is so low as to be substantially certain to occur on the issuance date. 16

19 b. Deduction for year-of-conversion interest accruals may be denied in the case of some in-artfully drafted instruments. See, e.g., Scott Paper Co v. Commissioner, 74 T.C. 137 (1980). (4) Subject to limited exceptions, 249 generally denies any deduction under Reg (c) for retirement premium to the extent the debt is converted into stock or repurchased at a FMV in excess of issue price. Any excess of the value of the stock issuance over the amount of the debt is treated as a non-deductible capital raising transaction. (5) Conversion feature does not cause convertible debt to be a CPDI. See Reg (a)(4). (b) Contingent Convertible Debt Rev. Rul (iii) (iv) (v) Reason for Instrument. Obtain a current deduction for the value of the conversion feature by causing convertible debt to be subject to the CPDI rules. Instrument Terms. 20-year, convertible bond issued at $625 with a payment of $1,000 at maturity. Conversion price is significantly out of the money at issuance. DI is part of an issuance that is not marketed or sold in substantial part to persons indifferent to U.S. tax consequences. Beginning in year 3, if the market price of instrument exceeds 120% of accreted value, contingent interest is payable in an amount equal to the greater of (1) cash dividends on a share, or (2) y% of market price of the DI. Thus, interest payments are effectively contingent on appreciation in the equity value of the issuer s stock. Holder can exercise a put at end of year 3 and year 8, and receive the accreted value. Issuer can satisfy the holder put in cash or shares, or a combination thereof. Holdings: (1) Non-contingent bond method applies to the DI, and accrual of OID is based on the projected payment schedule associated with a comparable non-convertible bond. (2) 163(l) does not disallow the interest deduction. The convertibility and holder put (which may be satisfied by the issuer in equity) are each treated as holder options. These do not trigger 163(l) if not substantially certain to be exercised on the issue date. 17

20 (3) 249 would apply to any redemption or conversion of the bonds and disallow deduction for retirement premium (excess of FMV over issue price on retirement). (vi) Notice IRS considering whether, as a policy matter, the results of Rev. Rul are appropriate in making application of the CPDI rules to contingent convertibles essentially elective. (vii) Senate Version of 2004 JOBS Act. Proposed to limit accrual on contingent convertibles to the yield on a comparable convertible debt instrument. This would limit the OID accruals to the expected value of any contingent cash payments. However, the proposal was not enacted into law. Thus, Rev. Rul continues to govern. (c) Call-Spread Convertibles (IRS Advice Memo ). Example of a Transaction. (1) X s stock is trading at $20 per share. X issues a $1,000 5 year face amount note with nominal interest. The note is convertible into X shares at $25 per share. (2) X pays a bank $300 to buy a call option (the Hedge) on its own shares at $25 per share. The Hedge is exercisable in tandem with the conversion feature of the Notes and intended to cover any stock issuance in connection with conversion of the Notes. (3) X writes the bank a warrant at $50 per share and receives a $200 premium. The warrant, unlike the Hedge, is designed to be separate from the Notes. For example, the warrant is separately tradable and only exercisable on a specified date 6 months after maturity of the note. The AM describes other indicia of separateness of the warrant and the note. Intended Tax Treatment. (1) Under Reg (integration rules), the Hedge is integrated with the Notes to create a synthetic, fixed rate security with $300 of OID. (2) The warrant is treated as a separate transaction not integrated with the Hedge or the Notes otherwise, if integrated, the OID accruals would be limited to the issuer s out of pocket costs of $100. Issuer excludes the cash received on the warrant from taxable income under (iii) AM

21 (1) IRS rules that issuer s treatment would be respected, based on certain factual assumptions: a. Facts demonstrating separateness of Hedge and warrant, and integration of Hedge with the Notes. b. FMV pricing of the Hedge and the warrant i.e., values are not inflated to create non-economic OID. c. Existence of a significant spread between Hedge and the warrant. (2) Other technical issues pertinent to the issuer s interest deduction: a. AHYDO limitations if OID exceeds stated thresholds. b. 249, if the debt instrument converts before the OID has been amortized. c. 163(l) need to ensure that conversion price is sufficiently out of the money on issuance for conversion not to be a substantial certainty. 19