Financial Transactions Committee Current Developments

Transcription

1 Financial Transactions Committee Current Developments Craig Gibian, Partner, Shearman & Sterling LLP Richard Larkins, Partner, Ernst & Young LLP Agenda Recently Proposed Treasury Regulations (CDSs, NPCs, 1256 Contracts) GLAM Investment in Commodities by RICs Cases (Samueli, Pritired) 1 Recently Proposed Treasury Regulations On September 15, 2011, Treasury Regulations were proposed that, if finalized in their current form, would impact a variety of financial transactions. The highlights of the proposed regulations include: Prescribing the proper treatment of credit default swaps (CDSs); Expanding the definition of contracts to be treated as notional principal contracts (NPCs); and Further to the enactment of section 1256(b)(2)(B) as part of the Dodd-Frank Act, clarifying the types of swaps that will not be treated as section 1256 contracts. 2

2 Recently Proposed Treasury Regulations: Credit Default Swaps In Notice , the IRS stated that a CDS may be analogized to an option, an NPC, a guarantee and insurance. The proposed regulations provide that contracts commonly referred to as... credit default swaps would be subject to the NPC rules. Would a CDS be subject to the NPC rules if it otherwise fails the requirements for an NPC (e.g., one upfront payment and one potential payment at maturity)? Would a CDS written by an insurance company always be treated as an NPC? While treatment of CDSs as NPCs would resolve much of the uncertainty regarding CDSs, some uncertainty would remain. The timing rules for CDSs would remain unclear until final rules are provided addressing the timing of income and deductions for contingent NPCs. While the proposed regulations make clear that a CDS would be an NPC even if the contract provides for physical delivery, the tax accounting for such a contract is not entirely unclear. 3 Recently Proposed Treasury Regulations: Notional Principal Contracts The proposed regulations would expand the definition of contracts to be treated as NPCs. First, while one party to a contract must make two or more payments for such contract to be treated as an NPC, the proposed regulations would treat certain bullet swaps and potentially other contracts as NPCs by treating an amount that is fixed on one date and paid or otherwise taken into account on a later date as a payment for this purpose. Open questions remain about the timing and character of bullet swaps, and precisely which contracts with a single payment at settlement would be subject to the NPC rules as opposed to treatment as forward contracts or other non-npc contracts. Second, the proposed regulations expand the definition of specified index to explicitly include non-financial indexes. As an example, the preamble specifically states that weather swaps would be treated as NPCs under the proposed regulations. 4

3 Recently Proposed Treasury Regulations: Section 1256 Contracts Section 1256(b)(2)(B), enacted as part of the Dodd-Frank Act, excludes from section 1256 treatment certain enumerated swaps or any similar agreement. The proposed regulations provide that a section 1256 contract does not include any contract, or option on such contract, that is an NPC. The proposed regulations thus look to the tax rules for excluding contracts from section 1256 treatment even if such contracts trade as futures contracts regulated by the CFTC. The proposed regulations also provide that, among other requirements, a futures contract would not be considered a section 1256 contract if it is required to be reported as a swap under the Commodity Exchange Act. 5 Worthless Stock Losses and Bad Debt Deductions - Rev. Rul , Situation 2 USP Facts USP, a domestic corporation, owned all of the stock of FS, a foreign corporation. FS was indebted to USP and to trade creditors. Liabilities of FS exceeded the FMV of FS's assets, including goodwill and going concern value. Deemed liquidation FS FMV: $30 Liabilities: $75 Liabilities greater than FMV of assets, including goodwill and going concern value * Amounts for illustration purposes only Transaction FS elected to be treated as an entity disregarded as separate from USP under Reg (c). Ruling FS s election to be treated as a disregarded entity is treated as a dissolution of FS into USP. The transaction does not qualify as a tax-free liquidation under Section 332 because the FMV of FS s assets does not exceed its liabilities. In determining the FMV of FS s assets, intangible assets such as goodwill and going concern value must be taken into account. USP is entitled to a Section 165(g)(3) worthless stock deduction and may be entitled to a deduction for a partially worthless debt under Section 166. See FSA (analysis supplanted by Rev. Rul ). 6

4 Worthless Stock Losses and Bad Debt Deductions GLAM , Situation 1 X FY 20% B = $30 FZ 80% B = $100 FMV = $100 B = $120 L = $110 (non-securities owing to X) CTB Election Facts X, a domestic corporation, owns all of the stock of FY, a foreign corporation, and 80% of the stock of FZ, another foreign corporation. FY owns the remaining 20% of the FZ stock. FZ is indebted to X and FZ s liabilities exceed the FMV of its assets. Transaction FZ makes a check-the-box election ( CTB Election ) to be treated as a partnership under Reg (c). FZ is deemed to distribute all of its assets and liabilities to its shareholders in liquidation, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. See Reg (c)(1)(i). 7 Worthless Stock Losses and Bad Debt Deductions GLAM , Situation 1 X FY 20% B = $30 FZ 80% B = $100 FMV = $100 B = $120 L = $110 (non-securities owing to X) Conclusions FZ s CTB Election is treated as a dissolution of FZ into X and FY, each of which are entitled to a Section 165(g) worthless stock deduction. The change in FZ s entity classification results in a new obligor under Reg but it is not a significant modification for purposes of Section Notwithstanding the GLAM s change in obligor conclusion, no mention was made with respect to retesting FZ s debt as equity for US federal tax purposes. FZ s CTB Election does not affect the liabilities of FZ with respect to its creditor, X, under local law and those liabilities survive the deemed dissolution. Compare the GLAM s focus on the federal tax fictions for purposes of Reg with the local law reality for purposes of its creditor analysis. Because FZ s liabilities owing to X survive the deemed dissolution, insolvent FZ s creditor, X, is not entitled to a Section 166 bad debt deduction solely based on the CTB Election. Cf. Rev. Rul

5 Investments in Commodities by RICs Income from trading in commodities is not qualifying income for purposes of satisfying the gross income requirement for a regulated investment company ( RIC ). The Internal Revenue Service has addressed the treatment of commodity-linked derivatives, including in Rev. Rul and Rev. Rul Dozens of RICs have received private letter rulings related to the treatment of income from commodity-linked structured notes and CFCs holding commodities. Recently, the Internal Revenue Service has indicated that it is taking a pause from issuing any more such private rulings. 9 Samueli v. Commissioner Brief Facts: Taxpayer financed a purchase of zero coupon bonds with a margin loan. Taxpayer then loaned the zero coupon bonds to the lender for a specified term, with a right to a return of such securities on two specified dates during such term. Taxpayer used the cash collateral posted by the lender to repay the margin loan. Upon return of the zero coupon bonds more than one year later, taxpayer sold such securities. Taxpayer s Intended Tax Result: Taxpayer reported a long-term capital gain upon the ultimate disposition of the zero coupon bonds and interest expense with respect to certain cash collateral fees. Tax Court: The court held that the securities lending arrangement did not qualify under section 1058 because the agreement, by not providing taxpayer with the ability to terminate on short notice, impermissibly reduced taxpayer s risk of loss and opportunity for gain as required by section 1058(b)(3). Ninth Circuit: Upheld the Tax Court s decision with respect to the application of section 1058, but noted that the decision does not necessarily imply a conclusion that a securities loan must be terminable upon demand to satisfy section The court also addressed other taxpayer arguments supporting capital gain treatment. 10

6 Pritired 1, LLC v. United States Brief Facts: Pritired 1 received $300 million from two US companies (Principal Life Ins. Co. and a US financial institution) and invested in French entities (SAS) along with two French banks. Pritired 1 contributed $300 million, and the French banks contributed $930 million. SAS paid $300 million back to the two French banks and issued $455 million of stock and $475 million of convertible debt in exchange for a $1.2 billion investment in a portfolio of financial instruments. SAS paid French income tax on the income from the investment, and the two US companies claimed foreign tax credits on the entire $1.2 billion investment pool. The District Court concluded that the shares of SAS held by Pritired more closely resembled debt and the arrangement was in essence a loan. The court also found the Pritired transaction lacked economic substance because, they concluded, there was no reasonable possibility of profit apart from the tax benefits (IES Indus., Inc. v. U.S., 253 F.3d 350 (8 th Cir. 2001)). The court characterized the transaction as a $300 million loan to the French banks at belowmarket rates with tax benefits which converted the yield on exceedingly low-risk securities to an exceedingly high rate. Absent the FTCs, the economic realities suggest that a corporation would not choose to earn less money on a transaction than could be generated by general obligation municipal bonds. 11