Tax Update. About the Author. RICs Get Welcome Breathing Room on Commodity-Linked Notes and CFCs Alpha Here We Come! in this issue

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1 December 2006 RICs Get Welcome Breathing Room on Commodity-Linked Notes and CFCs Alpha Here We Come! The Internal Revenue Service (the Service) recently issued a private letter ruling to a regulated investment company (RIC) addressing the treatment of income and gain from certain commodity-linked notes (CLNs), and the treatment of income from a wholly-owned controlled foreign corporation (CFC) for purposes of Section 851(b)(2) of the Internal Revenue Code of 1986 (Code). 1 The ruling held that income and gain from certain CLNs, and income from a wholly-owned CFC, constitutes qualifying income under Section 851(b)(2). 2 An investment company is not entitled to the beneficial flow-through tax treatment available to a RIC unless, among other requirements, at least 90 percent of its gross income is derived from: dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock or securities (as defined in section 2(a)(36) of the Investment Company in this issue 3 Speakers Corner 4 Service Gives New Meaning to Meaningless Gesture Doctrine for All Cash D Reorganizations 6 Using Transfer Restrictions in Bankruptcy to Protect Net Operating Losses 8 Pepper Hamilton LLP Tax Practice Group About the Author Gregory J. Nowak is a partner in Pepper Hamilton LLP s Financial Services Practice and a member of the Investment Management Practice Group. He heads Pepper s alternative investments team. At Pepper, Greg has been instrumental in the development of the firm s hedge fund and structured finance (collateralized debt offering (CDO) and collateralized loan offering (CLO)) representations. Pepper has been involved in approximately $8 Billion in CDO transactions since In fact, as the representative of a collateral manager, Pepper was involved in one of the first all-synthetic CDO offerings, where the Class A investor bought in through an ISDA swap and the underlying investments were all ISDA credit default swaps. Modern CDO transactions use up-front cost, cash smoothing and interest rate swaps as part of their capital structures, and B-spokes as part of their eligible investment pools. Before joining Pepper in 2002, Greg served as Executive Vice President and head of mergers and acquisitions and product development (a non-legal position) for Gartmore Global Investments, Inc Before joining Gartmore, Greg was in private practice as a partner in another large Philadelphia law firm. Active in professional and civic organizations, Greg served as chairman of the American Bar Association Tax Section s Regulated Investment Company Committee from 1995 to He served as vice chair from 1993 to He also was chairman of the Philadelphia Bar Association Tax Section s Exempt Organizations Committee from 1998 to Greg is a 1984 graduate of Cornell Law School and has his LL.M. in Taxation from New York University Law School in 1988.

2 Act of 1940, as amended (the 40 Act)) or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies, and net income derived from an interest in a qualified publicly traded partnership. 3 Unlike stocks and bonds that generate both income and the possibility of gain or loss, direct investments in commodities generate only the potential for gain or loss. Pepper Perspective Both of these holdings are welcome news for mutual funds and closed-end funds (both of which are RICs) that increasingly are finding it difficult to realize alpha without purchasing some of the exotic alphabet-soup instruments being manufactured by Wall Street these days. Alpha refers to the abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model. 4 Managers that beat their benchmark (or expected return targets) are said to have created alpha. In a large, efficient market, that is becoming increasingly more difficult to do. So, managers look for new ways to add positive returns. CLNs create the opportunity for a RIC to benefit from investments in commodities after a fashion and CFCs open the door, at least part of the way, for RICs to invest in controlled foreign corporations, including B-spokes and similar structured finance investments. Income and Gain from Commodity-Linked Notes Why This Private Letter Ruling is Important In Revenue Ruling , the Service ruled that a Swap contract where the reference obligation was a commodity index was not a security for purposes of section 851(b)(2), and that income from such a Swap contract was not qualifying income for purposes of section 851(b)(2) because the income from the contract was not derived with respect to the RIC s business of investing in stocks, securities or currencies. 5 The Service later clarified its position with respect to certain commodity-related instruments. In Revenue Ruling , the Service indicated that Rev. Rul was not intended to preclude a conclusion that income from certain instruments (such as certain structured notes) that create a commodity exposure for the holder is qualifying income under section 851(b)(2). 6 Pepper Perspective The allowable nature and extent of the commodity exposure is the open question. Unlike stocks and bonds that generate both income (as dividends or interest) and the possibility of gain or loss (due to market price movement, change in credit risk, change in perception, etc.), direct investments in commodities generate only the potential for gain or loss. A structured note backed by a pool of commodities, however, interjects a credit risk component, as well as an interest factor (as compensation for the credit risk), and therefore is different in nature and extent from the underlying commodities. Such structured notes are securities thus the conclusion in Revenue Ruling that gain and income from such structured notes could constitute qualifying income for purposes of Section 851(b)(2). Priv. Ltr. Rul is the third private letter ruling issued during 2006 in which the Service ruled that income and gain arising from certain CLNs constitutes qualifying income under Section 851(b)(2). 7 These rulings rely on the definition of a Security in Section 2(a)(36) of the 40 Act, which includes any interest or instrument commonly known as a security. 8 Because the RICs in the rulings had represented that the CLNs met the requirements to be considered predominantly a security under section 2(f)(2) of the Commodities Exchange Act, 7 U.S.C. 2, and given the features of the CLNs in issue, the Service ruled that income and gain arising from the CLNs constituted qualifying income under Section 851(b)(2). 9-2-

3 Income from Controlled Foreign Corporations The second issue addressed in Priv. Ltr. Rul is whether income from a RIC s whollyowned CFC subsidiary (which generates so-called Subpart F income under the Code) constitutes qualifying income under Section 851(b)(2). 10 Subpart F income constitutes qualifying income under section 851(b)(2) to the extent that there is a distribution out of the earnings and profits of the taxable year that are attributable to the amounts so included. 11 Prior to the ruling, there was concern that the phraseology of Section 851(b)(2) could be construed to create a negative inference that inclusions of income under Subpart F do not constitute qualifying income under section 851(b)(2) to the extent that there has not been a distribution out of the earnings and profits of the taxable year that are attributable to the amounts so included. The private letter ruling makes no mention of any potential negative inference to be drawn from such language, and, to the contrary, the Service ruled that income derived by the RIC from its investments in a wholly-owned CFC, whether or not attributable to Subpart F income, is income derived with respect to the RIC s business of investing in the stock of such CFC and thus constitutes qualifying income under section 851(b)(2). 12 Pepper Perspective B-Spokes and Alpha It is rare that a RIC holds 100 percent of the equity interest of any corporation due to diversification requirements, Section 12 of the 40 Act limits on tiered structures, and other constraints. In the case at hand, the RIC was using the CFC as a trading vehicle. There is another instance in which this fact pattern may prove relevant so-called B-spoke investments. B- spokes are a recent structured finance innovation and they increase the possibility that a RIC could be deemed to hold 100 percent of an equity interest of an offshore entity (perhaps a CFC), and the ruling is welcome clarification. In a typical B-spoke, a special purpose ring-fenced entity is formed offshore (usually in Cayman or BVI) and different traunches of interest are created. The assets held by the B-spoke master trust can be a credit default swap or any financial instrument that creates risk and cash flows that can be segregated into separate asset pools that can be ring-fenced. The subscription speakers corner Christian Wood spoke at the Western PA Tax Conference on Washington Updates on January 5, Annette Ahlers and Todd Reinstein will speak at the ABA Tax Section Midyear Meeting in Hollywood, Friday, January 19-20, Ms. Ahlers will be a panelist on Preserving NOLs in Bankruptcy: How, When and Why. Mr. Reinstein will be a panelist on Practical Implication of Proposed Tangible Asset Capitalization Regulation. quotable Todd Reinstein was quoted in the January 4, 2007, edition of the BNA Daily Tax Report in an article entitled IRS Amendment Limits Section 199 Benefits Where Passive Activity Rules Limit Losses. announcements We re pleased to announce that Todd Reinstein has been elected to partnership effective January 1, agreement for each B-spoke traunch allows the holder to elect (i.e., check the box) either flow-through or corporate treatment for U.S. federal income tax purposes with respect to the traunch, provided the holder owns 100 percent of the traunch. If flow-through is elected, the holder needs to deal with Rev. Rul and its progeny. If, on the other hand, corporate treatment is elected, and the holder is a RIC, the B-spoke becomes a CFC and the question of income qualification arises; that question has been answered in the affirmative for one RIC by Priv. Ltr. Rul

4 B-spokes likely are to be deemed investment companies described in Section 3(c)(1) and 3(c)(7) of the 40 Act, so the RIC must run the gauntlet of Section 12 and Section 7 of the 40 Act, as well as various anti-abuse provisions, and must over come standard restrictions under Regulation S under the Securities Act of 1933 that prohibit sales in the U.S. to other than institutional investors. No one ever said the pursuit of alpha was easy or for the faint of heart! Endnotes Authors: Gregory J. Nowak nowakg@pepperlaw.com R. D. David Young youngrd@pepperlaw.com 1 I.R.S. Priv. Ltr. Rul (August 10, 2006). 2 I.R.S. Priv. Ltr. Rul (August 10, 2006). 3 I.R.C. 851(b)(2). 4 Investopedia.com, Alpha, (last visited January 5, 2007). 5 Rev. Rul , I.R.B Rev. Rul , I.R.B I.R.S. Priv. Ltr. Rul (August 10, 2006); I.R.S. Priv. Ltr. Rul (June 1, 2006); I.R.S. Priv. Ltr. Rul (April 10, 2006) I.R.S. Priv. Ltr. Rul (August 10, 2006). 11 I.R.C. 851(b)(2). 12 I.R.S. Priv. Ltr. Rul (August 10, 2006). Service Gives New Meaning to Meaningless Gesture Doctrine for All Cash D Reorganizations On December 18, 2006, the IRS issued Temporary Regulations regarding the qualifications of certain transactions as tax-free reorganizations where, by virtue of the fact that the same owners hold all the stock of the transferor and the transferee corporations, no stock or securities of the acquiring corporation are issued and distributed. An All Cash D Reorganization The prototypical example is the all cash D reorganization, in which the transferor sells or transfers its assets to a related corporation without any exchange of stock or securities. Example: A owns all the stock of T and S. The T stock has a fair market value of $100. T, the transferor, sells all its assets to S, the transferee, in exchange for $100 of cash and immediately liquidates. Because there is complete shareholder identity, no S stock is issued or distributed in the transaction. Section 368(a)(1)(D) specifically states that a transfer to a controlled corporation (S, in our example) constitutes a D reorganization only if stock or securities of the controlled corporation (S) are distributed in a transaction that qualifies under Section 354. Section 354 is the provision of the Code that permits shareholders of the transferor corporation in a reorganization to exchange their stock in that corporation for stock of the acquiring corporation. Section 354(b)(1) provides, however, that Section 354 does not apply to a D reorganization unless the transferee receives substantially all of the transferor s assets, and the transferor distributes the transferee s stock it receives in the transaction. In an all cash D, however, the transferee does not issue any stock rather it pays for the acquired assets with cash. -4-

5 The Meaningless Gesture Doctrine Taxpayers have argued that this type of transaction could not constitute a D reorganization because stock of the transferee corporation was not distributed. The courts and the IRS have, nevertheless, held this type of transaction to qualify as a D reorganization reasoning that the issuance of further stock where the transferor corporation already owned all of the stock of the transferee corporation was a meaningless gesture. The scope of the meaningless gesture doctrine was unclear. For example, did it apply to the circumstances where the cross-ownership was not identical but the transferor and transferee were under common control? The Temporary Regulations answer this and other questions, giving greater meaning to the meaningless gesture doctrine. The Temporary Regulations The Temporary Regulations provide, inter alia, that: in cases where the same person or persons own, directly or indirectly, all of the stock of the transferor and the transferee corporations in identical proportions, the distribution requirement under Section 368(a)(1)(D) will be treated as satisfied even though no stock is actually issued in the transaction for purposes of the above, an individual and all members of his family, as defined in Section 318(a)(1), will be treated as one individual a de minimis rule is provided in determining the existence of shareholder identity and proportionality, which is illustrated in Example 4 of the Regulations as a one percent ownership level non-voting, non-convertible preferred stock, which is limited and preferred as to dividends and liquidation and redemption rights, is disregarded for purposes of determining shareholder identity and proportionality in each case where it is determined that the same person or persons own all the stock of the transferor and transferee corporations in identical proportions, a nominal share of stock of the transferee corporation will be deemed issued in addition to the actual consideration exchanged in the transaction. The IRS and Treasury are presently undertaking a broad study of the issues related to acquisitive all cash D reorganizations and specifically have indicated that the Temporary Regulations may change upon completion of the broader study. Pepper Perspective The IRS and Treasury are presently undertaking a broad study of the issues related to acquisitive D reorganizations and specifically have indicated that the rules described above may change upon completion of the broader study. To aide in the broader study, the IRS and Treasury requested comments on: whether the meaningless gesture doctrine is inconsistent with the distribution requirement in Section 368(a)(1)(D) and Section 354(b)(1)(B) the extent, if any, to which the continuity of interest requirement should apply to D reorganizations. Consistent with the adage that no good deed goes unpunished, the IRS s attempt to clarify the meaningless gesture doctrine may well have created a new area of uncertainty for certain triangular reorganizations by deeming an issuance of stock by the transferee in transactions covered by the Temporary Regulations. Author: Joan C. Arnold arnoldj@pepperlaw.com -5-

6 Using Transfer Restrictions in Bankruptcy to Protect Net Operating Losses Bankruptcy courts often place transfer restrictions on the bankrupt corporation s stock and debt to preserve valuable tax attributes, such as net operating losses (NOLs). 1 The transfer restrictions generally fall within the court s authority to control the bankrupt corporation s property under Section 362(a)(3) of the Bankruptcy Code. The Second Circuit endorsed this idea in its Prudential Lines decision, which upheld a Bankruptcy Court injunction that prevented one group member from taking a worthless stock deduction on the bankrupt member that would have would have eliminated the bankrupt member s NOL. 2 The Second Circuit ruled NOL s are property of the bankrupt corporation, and that transfer restrictions are appropriate controls to protect the NOLs. 3 Transfer Restrictions in General Transfer restrictions in bankruptcy can preserve NOLs from a variety of potential pitfalls. The most common reasons for transfer restrictions are: (1) preventing a majority shareholder from claiming a worthless stock deduction, which basically eliminates the bankrupt corporation s NOLs, as in Prudential Lines; (2) preventing an ownership change while the corporation is in bankruptcy; 4 (3) maintaining sufficient old and cold stockholders and debt holders so that the bankrupt corporation satisfies the requirements for the Section 382(l)(5) 5 bankruptcy exception; 6 and (4) preventing a second ownership change within two years after qualifying for the Section 382(l)(5) bankruptcy exception. 7 Notwithstanding Prudential Lines and other subsequent decisions, 8 the power of bankruptcy courts to restrict stock and debt transfers to preserve NOLs may have some constraints. In a 2005 decision, the Seventh Circuit vacated as moot a Bankruptcy Court injunction that prevented a bankrupt corporation s ESOP from selling shares of the corporation. 9 The injunction s purpose was to prevent an ownership change, but the Seventh Circuit noted in dicta that the transfer restriction was an unfair penalty on the parties subject to the restriction and was not appropriate merely to prevent a possible ownership change. 10 The Seventh Court commented that the transfer restrictions likely would be okay if the Bankruptcy Court had crafted a covenant to compensate parties harmed by the transfer restriction. 11 Recent Holding Requiring Sell-Downs In a recent bankruptcy decision, In re. Dana Corp., the Bankruptcy Court authorized certain sell down procedures to protect the loss corporation s NOLs. 12 The purpose of the sell-down mechanism was to preserve the bankrupt corporation s ability to qualify for the Section 382(l)(5) bankruptcy exception and meet the requirement that old and cold stockholders and debt holders retain 50 percent or more of the bankrupt corporation s equity. 13 Debt is generally considered old and cold if the debt arose at least 18 months before the bankruptcy filing or in the ordinary course of business. 14 The tax regulations generally permit an assumption that debt is old and cold as long as the debt holder is not a 5 percent shareholder when the loss corporation emerges from bankruptcy. 15 As a result, debt that might otherwise have favorable old and cold status when the debt is exchanged in bankruptcy for equity could be disqualified if the holder increases the amount of debt it holds and consequently becomes a 5 percent shareholder when the debt is exchanged for equity. To prevent this problem in In re Dana Corp. and preserve old and cold status under the presumption of Treas. Reg. Section (d)(3), the sell down procedures required certain debt holders to reduce their positions to a threshold amount. 16 The sell-down procedures did not otherwise restrict general trading in claims against the bankrupt company. 17 Sell-down provisions essentially prevented the creation of new 5 percent shareholders by forcing debt holders that acquire additional claims during the course of the bankruptcy to sell down their claims to the extent the additional claims would cause the debt holder to become a 5 percent shareholder. This, in turn, preserved sufficient old and cold stockholders and debt holders to enable the bankrupt corporation to qualify for the Section 382(l)(5) bankruptcy exception. Pepper Perspective Net operating losses can have significant value to bankrupt corporations when the corporation ultimately -6-

7 emerges from bankruptcy and attains profitability. Care should be taken to preserve the corporation s NOLs throughout and after the bankruptcy process. Consequently, internal financial personnel and tax advisors should be involved in initial bankruptcy planning so that appropriate transfer restrictions or sell down procedures can be implemented in a timely manner, including first day motions or shortly after bankruptcy proceedings begin. Endnotes Author: Bryan D. Keith Project Manager Washington, D.C keithb@pepperlaw.com 1 For a detailed discussion of transfer restrictions in bankruptcy see Henderson and Goldring, Tax Planning for Troubled Corporations, Section (2007 ed.). 2 In re Prudential Lines, 928 F.2d 565 (2nd Cir. 1991). 3 4 The loss corporation s value presumably is close to zero while in bankruptcy, and an ownership change as defined in Section 382(g) consequently would result in a limitation close to zero. 5 Unless otherwise noted, all references to IRC, the Code, or Section, are references to the Internal Revenue Code of 1986, as amended. All references to Treasury regulations or Treas. Regs. are to the Treasury regulations issued under the IRC. 6 Section 382(l)(5) provides that the annual Section 382 limitation on NOLs does not apply to an ownership change that occurs pursuant to a bankruptcy reorganization when specific requirements are met, including the retention of old and cold prebankruptcy shareholders or debt holders under Section 382(l)(5)(E) and Treas. Reg. Section (d). 7 A second ownership change within two years negates the benefits of the Section 382(l)(5) bankruptcy exception and triggers a limitation of zero for tax periods following the second change date. 8 See also, for example, In re Phar-Mor, Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993) (the court restricted Subscribe to Future Issues Did someone forward you this newsletter? Receive an electronic or hard copy of the monthly newsletter directly by returning this form by , facsimile or by mail to be added to our mailing list or to update your information. Send to Pepper Hamilton LLP, Hamilton Square, 600 Fourteenth Street, N.W., Washington, D.C , Attn: Homeira Ghorbani. (Fax or ghorbanih@pepperlaw.com) Name Title Company Address Phone Fax -7-

8 transfers by two minority 5 percent shareholders when the combined transfers would have caused a Section 382 ownership change). 9 In re UAL Corp., 412 F.3d 775 (7th Cir. 2005) (the Seventh Circuit commented in dicta that transfer restrictions used to prevent a potential ownership change are not an exercise in control over the corporation s losses in the same manner as the restriction used to prevent a worthless stock deduction in Prudential Lines). 10 In re UAL Corp., 412 F.3d 775 (7th Cir. 2005) In re Dana Corp., Case No (BRL) (Bankr. S.D.N.Y. Aug. 9, 2006) Section 382(l)(5)(E). 15 Treas. Reg. Section (d)(3). 16 In re Dana Corp., Case No (BRL) (Bankr. S.D.N.Y. Aug. 9, 2006). 17 Pepper Hamilton LLP Tax Practice Group Federal and International Tax Issues Annette M. Ahlers ahlersa@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com James W. Barson barsonj@pepperlaw.com Gordon R. Downing downingg@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard S. Goldberg goldbergh@pepperlaw.com Benjamin M. Hussa hussab@pepperlaw.com Michiel Muizelaar muizelaarm@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com Leonard Schneidman schneidmanl@pepperlaw.com Laura D. Warren warrenl@pepperlaw.com Christian T. Wood* woodc@pepperlaw.com R. D. David Young youngrd@pepperlaw.com State and Local Tax Issues Philip E. Cook, Jr cookp@pepperlaw.com Lance S. Jacobs jacobsls@pepperlaw.com Charles L. Potter, Jr potterc@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com Eric R. Stern sterne@pepperlaw.com *Admitted in Maryland only; supervision by principals of Pepper Hamilton LLP who are members of the DC Bar. For more information about any of our tax professionals listed, please visit our Web site, The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2006 Pepper Hamilton LLP. All Rights Reserved. PROMOTIONAL MATERIAL -8-