Debt Shmebt What's really at stake if a related party "note" is recast as equity? ABA Tax Section May 9, 2014

Transcription

1 Debt Shmebt What's really at stake if a related party "note" is recast as equity? ABA Tax Section May 9, 2014

2 Presenters Dave Friedel PwC Washington National Tax (202) Jon Zelnik KPMG Washington National Tax (202) Rob Ozmun PwC Boston, MA (617) Corina Trainer PwC Washington National Tax (202)

3 Agenda Topic Intra-Group Debt Springing Partnership Cross-Border Debt Total Time 30 min. 30 min. 30 min. 90 min. 2

4 Considerations Issuance Maintenance Repayment Compliance and Reporting Protective filings Cross-border transactions 3

5 Fact Patterns Overview Fact Patterns #1-8 Bank (1) Loan US Parent How do intercompany loans typically arise? Business arrangements Debt financed acquisitions Tax sharing agreements 7 Sub 1 1 2b 6 2a 3 Sub 2 Sub 3 4 Sub 4 CFC 1 CFC 3 8 CFC 2 5 CFC 4 4

6 Considerations Fact Pattern #1.0 Domestic parent-sub Sub 1 - US Parent + $1M principal 5% interest Sub 2 Sub 3 If treated as. Debt Issuance USP: Basis of $1M in note Annual Payments Federal tax consequences $50K interest income to USP $50K interest deduction to Sub 1 Treas. Reg matches intercompany income with the deduction timing, character, etc. Does Sub 2 s interest deduction establish a position under section 385(c)? CFC 1 CFC 2 Sub 4 CFC 3 CFC 4 State Tax Consequences Deductibility of Interest at Sub 1 Addback and / or State audit challenges Consideration what were proceeds from loan to Sub 1 used for Impact to Net Worth / Franchise Taxes at Sub 1 for states that addback intercompany debt Repayment Nontaxable to all parties 5

7 Considerations Fact Pattern #1.1 Domestic parent-sub Preferred shares US Parent If treated as. Equity Issuance If the note fails as debt, it should be considered preferred equity See FAA F Deemed issuance of Sub 1 preferred stock to USP. Basis = $1M Sub 1 CFC 1 $1M cash Sub 2 Sub 3 Sub 4 CFC 3 Annual Maintenance Section 301 distribution to USP Remember: No DRD, instead reduce basis. No deduction for Sub 1 upon payment Assuming Sub 1 is profitable, the positive and negative basis adjustments will offset and USP will have a $1M basis in the preferred stock of Sub 2 State tax consequences Dividend at USP consider State DRD rules - Could distribution be an extraordinary dividend under IRC 1059? What is the E&P at the sub (Pre-unitary?) Consider 301(e) Consider how preferred distributions from Sub 1 to USP may be characterized? Is it allocable or apportionable income? Impact to Net Worth / Franchise Taxes at Sub 1 for contribution CFC 2 CFC 4 Repayment Sub 1 redemption of USP s preferred Sub 1 shares. Section 302(d) What happens to USP s $1M of Basis in Sub 1 shares that were redeemed? What if USP cannot recover its basis in Sub 1? Section 301(c)(2)? 6

8 Considerations Fact Pattern #2a.0 Domestic parent and second tier sub Sub 1 US Parent + $1M principal 5% interest - Sub 2 Sub 3 Sub 4 If treated as. Debt Federal Tax Consequences USP is treated as having loaned cash directly to Sub 3. (See Fact Pattern 1) Non-controversial: this is clearly intercompany debt State Tax Consequences Intercompany transactions could be disallowed (e.g., addback rules and/or state audit adjustments) Interest income at the USP Unique state filing considerations. For example Kentucky s nexus consolidated return. Net worth - Potential impact on franchise taxes in states that include intercompany loans in tax base CFC 1 CFC 3 CFC 2 CFC 4 7

9 Considerations Fact Pattern #2a.1 Domestic parent and second tier sub Sub 1 US Parent Preferred shares $1M cash Sub 2 Sub 3 If treated as. Equity Federal tax consequences USP receives preferred shares in Sub 3 with Basis of $1M Where does the basis in the Sub 3 pref shares attach upon redemption? Sub 2 common stock vs. Sub 3 common stock Sub 4 CFC 1 CFC 3 CFC 2 CFC 4 8

10 Basis Shifting Authorities Gray v. Comm r, 56 T.C (1971). GCM (Apr. 24, 1974). Gray 90.4% Common stock Redemption 1960 redeemed all of Gray s preferred stock Court treated the redemption as essentially equivalent to a dividend cash 100% preferred stock Omark % Common stock What happens to Gray s basis in the 1960 preferred stock? The Tax Court added the eliminated basis to Omark s basis in the 1960 common stock In GCM 35793, the Service ruled that the proper adjustment is to increase Gray s basis in his Omark common stock 9

11 Considerations Fact Pattern #2a.1 Domestic parent and second tier sub Sub 1 US Parent Preferred shares $1M cash Sub 2 Sub 3 Sub 4 If treated as. Equity Federal tax consequences USP receives preferred shares in Sub 3 with Basis of $1M Where does the basis in the Sub 3 pref shares attach upon redemption? Sub 2 common stock vs. Sub 3 common stock State tax consequences Sub 3 ownership - Split between Sub 2 and USP Dividends potential impact for future distributions from Sub 3. o How will those dividends be characterized? o Allocable or apportionable income o Potential State DRD impact for USP and /or Sub 2 In certain cases: Equity component will be taxable CFC 1 CFC 3 CFC 2 CFC 4 Query: what would the results be if the loan were denominated in Euros? 10

12 Considerations Fact Pattern #2b Second tier sub and third tier sub Sub 1 CFC 1 + US Parent $1M principal 5% interest - Sub 2 Sub 3 Sub 4 CFC 3 Debt See Fact Pattern 1.0 If treated as. Equity If the note is recharacterized as equity.. the stock basis consequences of the redemption are important if Sub 2 subsequently sells Sub 3, or Parent sells Sub 2, or the Sub 2 or Sub 3 stock becomes worthless CFC 2 CFC 4 11

13 Considerations Fact Pattern #3.0 Parent to domestic disregarded sub Sub 1 CFC 1 US Parent + $1M principal 5% interest - Sub 2 Sub 3 Sub 4 CFC 3 If treated as. Debt Federal Tax Consequences USP is treated as having loaned cash directly to Sub 3. See Fact Pattern 1 Non-controversial: this is intercompany debt State Tax Consequences Consider states that do not follow the CTB regulations Intercompany transactions could be disallowed (e.g. addback rules and/or state audit adjustments) Interest income at the USP Net worth - Potential impact on franchise taxes in states that include intercompany loans in tax base and states that tax SMLLCs separately. CFC 2 CFC 4 12

14 Considerations Fact Pattern #3.1 Parent to domestic disregarded sub Sub 1 CFC 1 CFC 2 Preferred shares US Parent $1M cash Sub 4 CFC 3 CFC 4 Sub 2 Sub 3 If treated as. Equity Federal tax consequences USP receives preferred shares in Sub 4 with Basis of $1M, which springs Sub 4 into a partnership under default classification rules for domestic eligible entities Deconsolidates any lower tier includible corporations that Sub 4 might own Previously disregarded existing debt between Sub 3 and Sub 4, becomes regarded Numerous potential adverse consequences How is that liability allocated among parties? Consider current gain negotiation Subsequent Sale or Transfer Consider 357(c) upon a subsequent transfer of sub 4. See Rev. Rul Compliance considerations Form 1065 filing obligation going forward? Issue K-1 s to USP and Sub 3 State tax consequences Filing requirements for Sub 4 and USP as partner 13

15 Considerations Fact Pattern #3.2 Parent to domestic disregarded sub Sub 1 US Parent Sub 2 Intercompany Debt Consequences Domestic debt springing into existence Previously disregarded debt between Sub 3 and Sub 4 becomes regarded Potential adverse consequences Sub 4 Sub 3 - Existing Debt + Cross-border debt springing into existence Previously disregarded debt between Sub 4 and CFC 3 becomes regarded Potential adverse consequences CFC 1 CFC 3 + CFC 2 CFC 4 Existing Debt - 14

16 Considerations Fact Pattern #4.0 Parent to foreign disregarded sub Sub 1 US Parent + $1M principal 5% interest Sub 2 Sub 3 If treated as. Debt Issuance USP is treated as having loaned cash directly to Sub 3 since Sub 4 and CFC 3 are disregarded for US tax purposes. See Fact Pattern 1 Still intercompany debt? See Treas. Reg (g) Annual Maintenance Dual consolidated losses Treaty considerations? Interest payments, withholding taxes, branch loss recapture rules Sec. 988 Transfer: What is CFC 3 s functional currency? Foreign currency translation issues (if not USD)? How does apply to the FX items? Sub 4 Repayment No gain or loss recognized, generally CFC 1 CFC 2 - CFC 3 CFC 4 Compliance Considerations Form 926 Form 5471 State Tax Consequences Consider states that do not follow the CTB regulations Intercompany transactions could be disallowed (e.g. addback rules and/or state audit adjustments) Interest income at the USP 15

17 Considerations Fact Pattern #4.1 Parent to foreign disregarded sub Sub 1 CFC 1 Preferred shares US Parent $1M cash Sub 2 Sub 3 Sub 4 CFC 3 + Existing Debt - If treated as. Equity Issuance CFC 3 could spring into a partnership or regarded corporation, causing the existing debt between disregarded Sub 4 and CFC 3 to spring into existence. Consider additional consequences of sprung cross-border debt Annual Maintenance $50k distribution from CFC 3 to USP. Sec. 301 and 302. Consider: Withholding taxes FX gains and losses FTC What if CFC 3 is cash method? Consider Sec. 267(a)(3) Repayment CFC 3 redeems its preferred shares from USP. Treatment going forward- regarded vs. disregarded? Subsequent Sale Where does the basis in the CFC 3 preferred interest attach upon redemption? CFC 2 CFC 4 Compliance considerations Form 926 filings Form 8865 filing obligation going forward? Year to begin filing State Tax Consequences? Other income included at USP from CFC 3 Filing requirements for CFC 3 and USP as partner 16

18 Considerations Fact Pattern #4.2 Parent to foreign disregarded sub Sub 1 US Parent Sub 2 Intercompany Debt Consequences Cross-border debt springing into existence Previously disregarded debt between Sub 4 and CFC 3 becomes regarded Potential adverse consequences Sub 3 Sub 4 + CFC 1 CFC 3 - Existing Debt CFC 2 CFC 4 17

19 Considerations Fact Pattern #5.0 Parent to foreign sub Sub 1 US Parent + $1M principal 5% interest Sub 2 Sub 3 If treated as. Debt Issuance USP is treated as having loaned cash directly to CFC 4. See Fact Pattern 1 Non-controversial: this is clearly NOT intercompany debt. Annual Maintenance See Fact Pattern 4.0. Repayment No gain or loss recognized, generally. Sub 4 Compliance Considerations Form 926 filings Form 5471 filings CFC 1 CFC 2 - CFC 3 CFC 4 State Tax Consequences Foreign interest implications at USP Consider unique consolidated / combined return implications For example NY/ NYC and the potential implications to the substantial intercompany transactions test. 18

20 Considerations Fact Pattern #5.1 Parent to foreign sub US Parent If treated as. Equity Issuance See Fact Pattern 2a.1 Sub 1 $1M cash Sub 2 Annual Maintenance $50k distribution from CFC 4 to USP. Sec. 301 and 302. See Fact Pattern 4.1. CFC 1 Preferred shares Sub 3 Sub 4 CFC 3 + Existing Debt - Repayment CFC 4 redeems its preferred shares from USP. Treatment going forward- regarded vs. disregarded? Subsequent Sale If disregarded CFC 3 sells CFC 4, where does USP s remaining basis in its CFC 4 preferred shares attach? Compliance considerations Form 926 filings CFC 2 CFC 4 State Tax Consequences Foreign dividend implications at USP Consider unique consolidated / combined return implications For example NY/ NYC and the potential implications to the substantial intercompany transactions test. 19

21 Considerations Fact Pattern #6.0 Domestic sub to foreign sub, across the chain Sub 1 US Parent Sub 2 + Sub 3 $1M principal 5% interest Sub 4 If treated as. Debt Issuance Sub 1 is treated as having loaned cash directly to CFC 4. See Fact Pattern 1 Non-controversial: this is clearly NOT intercompany debt. Annual Maintenance See Fact Pattern 4.0. Repayment No gain or loss recognized, generally. Compliance Considerations Form 926 filings CFC 1 CFC 2 - CFC 3 CFC 4 State Tax Consequences Consider unique consolidated / combined return implications For example NY/ NYC and Kentucky Nexus Consolidated Intercompany transactions could be disallowed (e.g. addback rules and/or state audit adjustments) Interest income at Sub 1 20

22 Considerations Fact Pattern #6.1 Domestic sub to foreign sub, across the chain US Parent If treated as. Equity Issuance See Fact Pattern 2a.1 Sub 1 Sub 2 Sub 3 Annual Maintenance $50k distribution from CFC 4 to Sub 1. Sec. 301 and 302. See Fact Pattern 5.1 Repayment CFC 4 redeems its preferred shares from Sub 1. See Fact Pattern 5.1. $1M cash Sub 4 Subsequent Sale Where does the basis in the CFC 4 pref shares attach upon redemption? CFC 1 CFC 2 Preferred shares CFC 3 CFC 4 Compliance Considerations Form 926 filings Listed transaction? Consider Notice ; Fast Pay State Tax Consequences Consider unique consolidated / combined return implications For example NY/ NYC and Kentucky Nexus Consolidated Impact of Foreign dividends at Sub 1 21

23 $1M principal 5% interest Considerations Fact Pattern #7 Local country debt push-down + - Sub 1 CFC 1 US Parent Sub 2 Sub 3 Sub 4 CFC 3 Debt Issuance Debt is disregarded Annual Maintenance Treaty considerations: Dual consolidated losses? Withholding tax treaties (5 or 15%) Country X treatment of DREs Sec 987 Repayment Nontaxable for US federal tax purposes Sec 987 Qualified Business Unit? If treated as. Equity Issuance Equity between Sub 1 and CFC 1 is disregarded Annual Payments Disregarded preferred dividend to Sub 1 Sec 987 Qualified Business Unit? Compliance considerations Form 926 CFC 2 CFC 4 Compliance considerations Form

24 Considerations Fact Pattern #8 Foreign disregarded CFC to regarded CFC $1M principal 5% interest + Sub 1 CFC 1 US Parent Sub 2 Sub 3 Sub 4 CFC 3 Debt Issuance Treated as Sub 1 loaned cash to CFC 2 Annual Payments No local country withholding Sub 1 interest deduction? Repayment No gain or loss recognized, generally. If treated as. Equity Issuance Sub 1 receives preferred shares in CFC 2 with a basis of $1M Annual Payments Dividend from CFC 2 to Sub 1 into the US Sufficient CFC 2 E&P? Possible FTCs under section 902 Repayment CFC 2 redeems its preferred shares from Sub 1. Treatment going forwardregarded vs. disregarded? - CFC 2 CFC 4 23

25 Appendix A PwC 24

26 Basis Shifting Tax Shelter Notice Cash In Step 1, Taxpayer acquires a 1% interest in foreign sub (FS) from foreign parent (FP) for cash. In addition, Taxpayer transfers cash to FP shareholders in exchange for an option to purchase 50% of the FP stock. Taxpayer U.S. Corp or Individual Option on 50% of FP 1 FP Shareholders 1% FP Foreign High E&P and Tax Basis FS Foreign

27 Basis Shifting Tax Shelter Notice (cont) In Step 2, FS redeems 100% of FP s interest. Taxpayer U.S. Corp or Individual 1% High E&P and Tax Basis FP Shareholders FP Foreign FS Foreign Stock Cash 2 FS Redeems FP Stock The redemption in step 2 is treated as a dividend under section 302. Section 318 applies to deem Taxpayer s potion to be exercised. In addition, section 318(a)(3) applies to attribute Taxpayer s ownership of FS to FP. Thus, FP is deemed to own 100% of FS before the redemption and 100% after the redemption. Because FP no longer owns any shares of FS, FP s basis in the FS shares shifts to Taxpayer in accordance with Example 2 of Treas. Reg (c). This presents the potential that the Taxpayer can then sell the FS stock at a loss. Notice provides that the basis does not shift if FP is not subject to U.S. tax on the redemption. Variations include the use of the transaction to reduce income or gain, and the transfer of the FS stock in a carryover basis transaction followed by the sale of the substituted high basis property.

28 Basis Shifting Authorities GCM (Feb. 21, 1974) Corp Decedent Heirs Corp Property 1. Bequest of Corp to heirs 2. Bequest of Property to Corp Property Basis = FMV of Corp + FMV of Property Facts The sole shareholder of a Corp died Under his will, all the stock of Corp was bequeathed to his heirs and certain property was bequeathed to Corp as well The bequest of property to Corp was intended to benefit the heirs Rule Section 1014: beneficiaries take a FMV basis in any property bequeathed to them The basis of the shares bequeathed to the heirs was increased to the same extent as if the property had been bequeathed directly to them and then contributed to the corporation Thus, the FMV of the property bequeathed to Corp was taken into account in determining the basis in Corp in the hands of the heirs 27

29 Heinz Taxpayer lost, notwithstanding substantial profit 1 Public Mkt Purchase of Parent Shares HL buys 3.5M Heinz Shares for $131M. Heinz HL HCC Cash 3 rd Party Bank Step 1: Heinz formed Heinz Credit Corp ( HCC ) and transferred the HCC stock and some leases to Heinz Leasing ( HL ). HCC, using funds borrowed from a 3 rd party bank, purchases 3.5m shares of Heinz on the open market, for approximately $131m, obtaining a cost basis in the shares.

30 Heinz Taxpayer lost, notwithstanding substantial profit Public Convertible Notec 3.325m shares Heinz HL 2 Redemption by Parent HCC sells 3.325M Heinz Shares back to Heinz in purported redemption in exchange for convertible note. HCC 3.5m shares Step 2: As part of the Heinz stock repurchase program, HCC transferred 3.325m shares of Heinz stock back to Heinz in exchange for a zero coupon convertible note. Heinz took the position that under 302, the basis of the recently purchased stock shifted to the remaining 175k shares held.

31 Heinz Taxpayer lost, notwithstanding substantial profit Public Heinz HL 3 Third Party Sale HCC Sells remaining 175,000 Heinz Shares to third party for $6.93M several months later, realizing $6M economic profit, but $124M tax loss due to basis shift on purported redemption. 3 rd Party Heinz stock $7m Cash HCC Step 3: HCC sells the remaining 175k shares to a third party for approximately $7m, realizing profit of approximately $6m, but recognizing $124m in capital losses. Meaningful Economics: Ironically, S actually made profit on both the third party sale and its subsequent exercise of the conversion privilege. Verdict: No redemption, no dividend, no basis shift. Business purpose found lacking for S to be involved in the transaction. Is that the right application of the business purpose requirement?

32 Blum v. Commissioner, T.C. Memo Mr. Blum Alfaside Limited Blum Trust 95% Benzinger GP 5% Benzinger LP Background: Taxpayer owned certain shares in Buy.com through a grantor trust formed in Presented with large potential capital gains, taxpayers engaged a promoter in a transaction (offshore portfolio investment strategy, or OPIS ) intended to generate capital losses. The advisor formed three special purpose entities in order to facilitate the planning: 1) Alfaside Limited ( Alfasade )was incorporated in the Isle of Man; 2) Alfaside acquired 100% ownership of Benzinger GP, Inc. ( Benzinger GP ); and 3) Benzinger GP and Alfaside formed Benzinger Investors LP ( Benzinger LP ).

33 Blum v. Commissioner, T.C. Memo Alfaside Limited 1 Mr. Blum 95% Benzinger GP 5% UBS $2.25M Cash Blum Trust Benzinger LP Step 1: Taxpayer wired $2.25m in cash to the Trust in order to purchase 10.5k UBS shares.

34 Blum v. Commissioner, T.C. Memo Mr. Blum $3M Cash Alfaside Limited Public Blum Trust 10.5k Shares 95% Benzinger GP 5% UBS Benzinger LP Step 2: Taxpayer also wired $3m in cash to UBS in payment for an equity swap agreement which required the Trust to pay Alfaside two specified payments on two specified dates.

35 Blum v. Commissioner, T.C. Memo Mr. Blum 3 Alfaside Limited Public Blum Trust 10.5k Shares 95% Benzinger GP 5% UBS Benzinger LP Step 3: The Trust purchased Benzinger GP call options from Alfaside, pursuant to which the Trust could require Alfaside to either sell its half of the stock of Benzinger GP, or pay a cash settlement calculated relative to Benzinger GP s net asset value.

36 Blum v. Commissioner, T.C. Memo Mr. Blum 3 Alfaside Limited Public Blum Trust 10.5k Shares 95% Benzinger GP 5% UBS Benzinger LP Step 3: The Trust purchased Benzinger GP call options from Alfaside, pursuant to which the Trust could require Alfaside to either sell its half of the stock of Benzinger GP, or pay a cash settlement calculated relative to Benzinger GP s net asset value.

37 Blum v. Commissioner, T.C. Memo Mr. Blum Alfaside Limited 10.5k Shares Blum Trust Public 95% Benzinger GP 4 UBS 5% Benzinger LP Step 4: Benzinger LP entered into a delayed settlement agreement on 10/16/98 with UBS to purchase 165k shares of UBS stock for $45m on 11/27/98, and treated the transaction as a purchase of stock as of the date of the delayed settlement agreement for tax purposes. The parties were not required to perform on the contract until 11/27/98.

38 Blum v. Commissioner, T.C. Memo Mr. Blum Alfaside Limited 10.5k Shares Blum Trust Public 95% Benzinger GP 5 UBS 5% Benzinger LP Step 5: Benzinger LP and UBS used put and call options to construct a collar on the shares. UBS stock closed below a certain level on the day of the delayed settlement agreement (10/16/98). This reset the strike price on the call options to 90%, equal to the strike price on the put options. In effect, Benzinger LP purported to purchase $45m in stock when the delayed settlement agreement was entered into, paid no money, received no stock, and entered into transactions that would cause it to never receive at least 90% of the stock.

39 Blum v. Commissioner, T.C. Memo Mr. Blum Alfaside Limited Blum Trust 10.5k Shares Public 95% Benzinger GP 6 UBS 5% Benzinger LP Step 6: On 11/27/98, UBS redeemed the 165k shares that Benzinger LP had acquired in the prior month (which were in the money).

40 Blum v. Commissioner, T.C. Memo Mr. Blum Alfaside Limited 7 $680k Blum Trust Public 165k options 10.5k Shares 95% Benzinger GP UBS 5% Benzinger LP Step 7: Simultaneously with Step 6, the Trust purchased 165k out of the money call options on UBS stock which were set to expire worthless on 12/28/98 for $680k.

41 Blum v. Commissioner, T.C. Memo Mr. Blum Alfaside Limited Blum Trust k Shares Public $3.2m 95% Benzinger GP UBS 5% Benzinger LP Step 8: On 12/28/98, the Trust sold its 10.5k shares it purchased in Step 1. The Taxpayer claimed that the 10.5k shares had basis shifted to them as a result of the option purchase by the Trust and by related Benzinger LP and claimed a loss of approximately $45m.

42 Blum v. Commissioner, T.C. Memo Holding: The court agreed with the IRS that the OPIS transaction lacked economic substance and held the entire series of steps was only undertaken to orchestrate a capital loss. The court noted that a taxpayer may not deduct losses resulting from a transaction that lacks economic substance even if the transaction complies with the literal terms of the code. The court noted that the advisor sought clients with substantial capital gains above a threshold minimum for the OPIS transaction. The court noted that the taxpayer did not approach the transaction as investors as no economic analysis or diligence of the transaction was performed; they merely agreed to the advisors terms. The significant losses were artificial, the taxpayer invested $6m, lost $1.5m, and generated $45m in losses. From an objective perspective, the court held that the mere presence of a profit potential does not automatically impute substance where a common sense examination of the transaction and the record reflects a lack of economic substance. The taxpayer asserted a good faith exception to the penalties applied as they relied on the advisor s opinion. However, the court disagreed holding that the opinion letter relied on false representations, the most crucial of which was that the taxpayer independently reviewed the economics of the investment strategy and believed it had a reasonable opportunity to earn a pre-tax profit. The taxpayer knew the representation was false, or would have known if he had read the opinion letter.

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