Establishing and Operating Treasury Centers

Transcription

1 Establishing and Operating Centers Taxation of Financial Products and Transactions 2015 Practicing Law Institute New York City January 8, 2015 Paul J. Crispino, General Electric Liz G. Hale, E&Y L.G. Chip Harter, PwC Mark H. Price, KPMG

2 Agenda I. Introductions II. Brief overview of key concepts Foreign currency gains and losses Subpart F rules applicable to FX gains and losses III. Center Issues Timing Issues Subpart F Netting Issues Section 267(a)(3)(B) Issues PricewaterhouseCoopers Page 2

3 Brief overview of key concepts Page 3

4 Key concepts for foreign currency gains and losses 1. Section 988 currency gains or losses are: Ordinary in character Sourced at residence of QBU 2. Section 988 transactions include: Accruing foreign currency denominated income or expense Foreign currency denominated debt Foreign currency forward contract, futures contract, option or similar financial instrument The disposition of foreign currency 3. Equity investments not included Page 4

5 Subpart F treatment of foreign currency gains and losses 1. Net foreign currency gains are foreign personal holding company income ( FPHCI ) 2. Net losses do not offset other categories of FPHCI unless election is made under Treas. Reg (g)(4). 3. Foreign currency gains and losses on interest-bearing liabilities are allocated and apportioned between subpart F and non-subpart F income based on the manner in which interest expense is allocated (absent special elections) 4. Certain foreign currency gains and losses are excluded from FPHCI under the business needs exception Page 5

6 Subpart F exception: Business Needs & Bona fide hedging transactions FX gain or loss is excluded from current subpart F income if either: FX gain/loss arises from qualifying transaction (the business needs exception) - FX gain/loss arises in normal course of trade or business - Item does not give rise to Subpart F income (other than FX income) - Item is not itself a currency derivative, or FX gain/loss arises from bona fide hedge of qualifying transaction - Standard generally based on the section 1221 standard for hedging, but expanded upon for subpart F purposes - Proper identification required! Page 6

7 Center Issues Page 7

8 Before Center FX 1 FX 2 Each entity interacts directly with Bank Alternatively, hedges for affiliates Will that qualify for tax hedging? Subpart F? +600 (-400) FX 3 FX 4 loan DRE/ Branch FX 6 FX 5 Cash poor s borrow from Bank Alternatively, cash rich s loan to cash poor s Can lender hedge that risk Bank FX 5 hedge FX 6 hedge Potential Application of the section 1092 straddle rules. 8 January 2015 PLI Current and Currency Issues Page 8

9 Basic Center fact pattern Common activities Creating better oversight and visibility Centralized investment s Loans in Hedges of business risks Loans in Hedges of business risks s Cash pool leader Reduce interest expense Extension of look through rules? Avoiding pitfalls of participation Hedging Hedges where necessary to manage net risk ISDAs & Dodd Frank Back to back hedges Timing whipsaws Bank Netting exposures 8 January 2015 PLI Current and Currency Issues Page 9

10 Issues with Realization Based FX Recognition Crucial to have offsetting FX gains and losses recognized in same tax year. s Multiple loans in Multiple loans in s Net 988 gain for a year is generally subpart F income under 954(c)(1)(D). Net 988 loss for a year is generally allocated against deferrable income (c)(ii). Bank Hedges where necessary to manage risk on gaps Even if the TC has a balanced book of positions, it can have net FX gain in one year with net FX loss in another year if offsetting gains and losses are not recognized in the same year. Page 10

11 Issues with Realization Based FX Recognition Strategies for avoiding timing mismatches. Have realization events for all positions shortly before year end. s Multiple loans in Multiple loans in s Hedges where necessary to manage risk on gaps Section 1092 straddle rules will defer realized losses to match with subsequent gains, but not visa versa hedge timing rules match hedge gains or losses with underlying gains or losses, but loans receivable or payable are not hedges. Mark to market accounting Bank Mixed Straddle Account under (b)-4? Securities dealer MTM accounting under 475. Page 11

12 centers MTM Accounting under 475 Can a TC be a section 475 securities dealer? 1 Multiple loans in Multiple loans in 2 TC regularly purchases securities in the normal course of its trade or business from customers as it lends to affiliates. How much activity needed? Related parties can be customers under 1.475(c)-1(a)(3). Hedges where necessary to manage risk on gaps 1.475(c)-1(a)(3)(iv) Example 1 illustrates that an internal hedging center can be a dealer. Dealer Elect out of negligible resale exception under 1.475(c)-1(c)(ii). Page 12

13 centers MTM Accounting under 475 Securities which must be marked under section 475 include: A note, bond, debenture or other evidence of indebtedness; 1 Multiple loans in Dealer Multiple loans in Hedges where necessary to manage risk on gaps 2 An interest rate, currency, or equity NPC; Any evidence of an interest in, or a derivative financial instrument in... any currency, including a short position, and any similar financial instrument in such a... currency; And a hedge of a security, including any position which manages the dealer s risk of... currency fluctuations.... Note that under 1092(d)(7) a FX debt liability is a short position in the currency for purpose of the straddle rules. Page 13

14 centers MTM Accounting under 475 Can a 475 dealer mark its FX debt liabilities to market under section 475? 1 Multiple loans in Multiple loans in 2 Treas. Reg (c)-2(a)(2) (debt issued by taxpayer not a security) vs. Dealer Hedges where necessary to manage risk on gaps I.R.C. 475(c)(2)(E) (short position in FX is a security) See, NYSBA Report on Subpart F Currency Issues Page 14

15 centers subpart F netting Subpart F characterization of FX gains 1. Internal treasury center can t qualify for subpart F dealer exception. Subpart F dealer exception requires unrelated customers. 1 Loans in Loans in 2 2. FX gain or loss on loans receivable is subpart F gain or loss netted within 954(c)(1)(D) unless it qualifies for the business needs exception of (g)(2)(ii). Business Needs Exception applies to FX gain or loss arising from a transaction entered into in the normal course of business which could not be reasonably expected to give rise to subpar F income other than FX gain. Dealer Hedges where necessary to manage risk on gaps Exception might apply to FX gain on a loan receivable if all interest on loan receivable is expected to qualify under 954(c)(6) and receivable will be held to maturity. Can be difficult to qualify, given the passive income look thru rules for related party interest and the periodic expiration of 954(c)(6). Entire FX gain or loss on a receivable is either subpart FX or not. Page 15

16 centers subpart F netting Subpart F characterization, cont d 3. FX gain or loss on an interest bearing loan payable is characterized between subpart F and non-subpart F income in the same manner as interest on the loan would be allocated under T & -12T. See, (g)(2)(iii). Can business needs exception apply instead? Deposit ($100 gain) 1000 Loan ($100 loss) 2 4. Given the asymmetric characterization of FX gains and losses on loans receivable vs. loans payable, serious subpart F mismatches can result from a balanced book of positions. In the example on the left, the entire FX loss on the loan receivable might qualify for the business needs exception, and therefore not reduce subpart F income, while a portion of the FX gain on the liability would be characterized as subpart F income because a portion of the interest expense on the deposit liability would be allocable to the passive treasury portfolio. Portfolio Even though the combination of the loans receivable and the deposit liabilities produces a net FX gain of zero as an economic matter, the asymmetric characterization of the gains and losses produces net subpart F income. Although the subpart F inclusion can not exceed the net earnings of the TC for the year, the effect can be to erode the deferral benefit of 954(c)(6) for related party interest earned by the TC. Page 16

17 centers subpart F netting Subpart F characterization, cont d Election under Treas. Reg (g)(4) can provide more symmetric subpart F characterization. Under a (g)(4) election, agrees to treat all section 988 gains and losses as subpart F GX gains and losses, allowing them all to be netted for purposes of 954(c)(1)(D) Deposit ($100 gain) 1000 Loan ($100 loss) 2 Any net 988 gain is FPHCI. Any net 988 loss is deductible against FPHCI. Revocable only with Commissioner s consent. Election works well for SPV s which can maintain balanced book of FX positions. Portfolio Election does not work well for operating entities that would want to take advantage of the business needs exception. Therefore, want to have TC in a separate that has no operations checked into it. Page 17

18 centers subpart F netting Subpart F characterization, cont d Asymmetric subpart F treatment of section 988 gains vs. interest rate related gains on securities. In example at left, assume that TC has a MTM gain of $20 on the fixed rate loans receivable, of which $10 is attributable to FX appreciation. 1 Floating Rate deposits Fixed rate term loans 2 floating to fixed interest rate swap Further assume that it has a $10 MTM loss on the floating rate deposits, all of which is attributable to FX fluctuations and a $10 loss on the interest rate swap. On the loans receivable, $10 of the gain is 988 gain falling in 954(c)(1)(D) and $10 is gain on securities falling in 954(c)(1)(B). Swap Dealer Both the $10 loss on the deposits and the $10 loss on the interest rate swap are 988 losses falling in 954(c)(1)(D). TC therefore has net 954(c)(1)(B) FPHCI of $10 which is not offset by the $10 of net 988 loss under 954(c)(1)(D). (g)(4) election does not solve this problem. Consider integrated hedge under Page 18

19 centers timing of interest deductions Timing of Deductions for Interest 1. Section 267(a)(3)(B) provides that a borrower from a related gets a deduction for interest expense only when interest is paid unless subpart F income to the lender. 1 Deposits from affiliates Interest Loans to affiliates Interest 2 2. In CCA , the IRS defined payment very narrowly, disregarding circular cash flows and interest payments financed by lender. 3. Application of section 267(a)(3)(B) in Center context produces duplication of e&p. Page 19

20 CCA Intercompany Loans FP A Taxpayer U.S. Interest Taxpayer borrowed funds from FP and deposited those funds into its General Account Taxpayer then paid interest on other intercompany loans owed to FP (as well as operational expenses to third parties) from its General Account The Service concluded under Battelstein/Davison that the borrowed funds were, in substance, the same funds used to satisfy the interest obligation resulting in an effective postponement of payments due and therefore interest deductions should be deferred under section 267(a)(3) The Service found compelling evidence that the interest payments should be traced to the FP debt: Taxpayer-FP loans either (1) netted borrowed principal against interest owed on other debts, (2) earmarked borrowed principal for outstanding interest obligations, or (3) were advanced close in time to interest payments Taxpayer s FP borrowings increased year after year, unrelated to temporary and unforeseeable adverse business conditions, unaccompanied by any infusion of capital, and without consideration of Taxpayer s ability to make payments of interest thereon Page 20

21 These materials have been prepared only for a general discussion of matters of interest and do not constitute professional advice. You should not act upon information contained in these materials without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained herein. Page 21