Yoram Keinan Taxation of Financial Instruments

Class 4

Transcript

1. Limitations on Interest Deductions 1
2. Overview • §163(a) allows the deduction of “all interest paid or accrued within the taxable year on indebtedness” • §§162 and 212 allow the deduction of business interest and investment interest, respectively • The ability to deduct interest is subject to various restrictions, depending on the type of interest at issue • Some sections disallow the deduction of certain kinds of interest outright, such as (i) interest incurred or continued to purchase or carry assets that produce tax-exempt income and (ii) debt that calls for a substantial payment tied to the value of the issuer’s or a related party’s stock • Other sections allow a deduction for interest on a deferred basis, including interest incurred in the current year to carry assets that will produce taxable income in a future taxable year 2
3. Interest Related to a Tax-Exempt Obligation §265(a)(2) • §265(a)(2) disallows a deduction for interest payments on debt “incurred or continued to purchase or carry” tax-exempt obligations. To allow the deduction of such interest expense would create an unwarranted opportunity for arbitrage • Example: taxpayer borrows $1,000 at 10% to invest in a tax- exempt bond paying 8% – Before tax, the taxpayer receives $80 and incurs expense of $100; this trade would not make economic sense – If the loss is deductible against the taxpayer’s other income (at 21%), then the transaction becomes profitable because the $100 deduction causes savings of $21, resulting in an after-tax profit of $1 • Potential for tax arbitrage was greater before tax reform in 12/2017, when the maximum corporate tax rate was 35% • §265(a)(2) prevents the creation of a deduction through the debt financing of an investment in tax-exempt state or local bonds 3
4. Incurred or Continued to Purchase or Carry (Rev. Proc. 72-18) • The crucial question is whether a debt was “incurred or continued to purchase or carry” a tax-exempt obligation • This is because a taxpayer who borrows to buy tax-exempts and a taxpayer who borrows against tax-exempts already owned are in virtually the same economic position and should be treated the same under §265(a)(2) • Interest is disallowed when a taxpayer incurs or continues indebtedness for the purpose of acquiring or holding tax-exempt obligations. This purpose may be established either by direct or circumstantial (i.e., indirect) evidence • In general, interest is not disallowed just because the taxpayer is concurrently paying interest on a debt and receiving tax-exempt interest, or because the taxpayer could sell tax-exempt securities to pay off the debt 4
5. Incurred or Continued to Purchase or Carry (Rev. Proc. 72-18) • §265(a)(2) may apply even if different entities within an affiliated group incur the borrowing and hold the tax-exempt securities. H Enterprises International v. Commissioner, 75 T.C.M. 1948 (1998), aff’d, 183 F.3d 907 (8th Cir. 1999) – Parent and Sub were members of a consolidated group – Sub declared a dividend and, a few days later, borrowed funds and immediately used part of those funds to pay the dividend to Parent – Parent used the funds to acquire investments including tax-exempt obligations – Tax Court held that a portion of Sub’s debt was incurred for the purpose of purchasing or carrying Parent’s tax-exempt obligations – Tax Court disallowed a deduction under §265(a)(2) for the portion of the interest relating to the debt used to fund the tax-exempt obligations – To establish the purposive connection under §265(a)(2), the court reasoned that Parent’s activities were relevant in determining the purpose of Sub’s borrowing, and that focusing only on the Sub/borrower would mean that its purpose would always be acceptable, thereby frustrating the legislative intent of §265(a)(2) – See also Rev. Rul. 2004-47, discussing numerous situations where one member of a group borrows money to lend to another member that is a dealer in tax-exempt obligations 5
6. Direct Evidence of Purpose • Direct evidence of a purpose to purchase tax-exempt obligations exists if the proceeds of indebtedness are used for, and are directly traceable to, the purchase of tax-exempt obligations. Wynn v. U.S., 411 F.2d 614 (1969), cert. denied, 396 U.S. 1008 (1970) • Direct evidence of a purpose to carry tax-exempt obligations exists if tax-exempt obligations are used as collateral for a debt. Wisconsin Cheeseman v. U.S., 338 F.2d 420 (1968) 6
7. Circumstantial Evidence of Purpose • In the absence of direct evidence, §265(a)(2) will apply only if the “totality of facts and circumstances” supports a reasonable inference that the purpose to purchase or carry exists • Need a “sufficiently direct relationship” between the borrowing and the investment in tax-exempts • Debt incurred for personal purposes (e.g., to purchase or improve a personal residence) does not have a sufficiently direct relationship to tax-exempt obligations • Similarly, debt incurred or continued by a taxpayer in connection with the active conduct of a trade or business ordinarily does not have a sufficiently direct relationship to tax-exempt obligations unless the borrowing was in excess of business needs. Rev. Proc. 72-18 7
8. De Minimis Exception • No inference of the requisite purpose will be made from circumstantial evidence if the taxpayer’s investment in tax-exempt obligations (“TEOs”) is “insubstantial” • Generally, an investment is presumed “insubstantial” if, in the case of an individual, the average amount of TEOs does not exceed 2% of the investor’s portfolio investments and any assets used in a trade or business; in the case of a corporation, the presumption exists if the average amount of the TEOs does not exceed 2% of the assets used in a trade or business. Rev. Proc. 72-18, §3.05 • Exception does not apply to dealers in TEOs 8
9. Interest Expense of Financial Institutions (§265(b)) • In the case of TEO acquired after 8/7/1986 by banks, thrift institutions, and other financial institutions that incur interest expense while holding tax-exempt obligations, the “purpose test” under §265(a)(2) does not apply • Instead, §265(b) denies the deduction of interest expense “allocable” to tax-exempt interest, regardless of the purpose for incurring the debt – Average adjusted basis of TEOs / average adjusted basis of all assets • A “financial institution” for this purpose generally is an entity that accepts deposits from the public in the ordinary course of its trade or business, and is subject to federal or state regulation as a financial institution. §265(b)(5) • This formulary allocation of interest expense to TEOs is prescribed “because of the difficulty of tracing funds within a financial institution, and the near impossibility of assessing a financial institution’s purpose in accepting particular deposits.” See Staff of the JCT, General Explanation of Tax Reform Act of 1986, at 563 (1986) 9
10. Applicable High Yield Discount Obligations (“AHYDOs”) 10
11. Overview • §163(e)(5) was enacted in 1989 to target the use of leverage in corporations, especially in the context of so-called leveraged buyouts • §163(e)(5) provides special rules for OID on AHYDOs • In general, an interest deduction is deferred until paid, and in some cases permanently disallowed in part, if the debt instrument is an AHYDO and certain conditions are met. §163(e)(5)(A) • No AHYDO regulations have been issued 11
12. Requirements for AHYDO – §163(i)(1) • The instrument is issued by a C corporation (but the rules also apply to partnership debt to the extent attributable to corporate partners) • Term of the debt is more than 5 years • The instrument’s YTM is equal to or greater than the applicable federal rate (“AFR”) plus 5% • The instrument has “significant OID” 12
13. Significant OID • A debt instrument has “significant OID” if on any test date the total accrued OID and interest exceeds the sum of – aggregate cash payments made by the “test date” and – the product of issue price and the YTM • Test date means the end of each accrual period after the 5th anniversary of the issue date • Examples of clear cases with significant OID include – (i) a zero-coupon bond with a term longer than 5 years, and – (ii) a 5+ year debt instrument with PIK interest 13
14. Special Rules for Testing for AHYDO • Any payment in stock or debt of the issuer is assumed to be made when it is required to be paid in cash or other property • Payments under the instrument are assumed to be made on the last day permitted under the instrument 14
15. Consequences of AHYDO • If the yield on an AHYDO does not exceed the AFR by more than 6%, then the rules simply defer the deduction for OID on the AHYDO until it is actually paid. §163(e)(5) • If the yield on the debt instrument exceeds the AFR by more than 6%, then a portion of the total return on the debt instrument (the “disqualified portion”) is permanently nondeductible and is treated when accrued as a distribution eligible for the dividends received deduction for corporate holders (the “dividend equivalent portion”). §163(e)(5) 15
16. Disqualified and Dividend Equivalent Portion • The “disqualified portion” is the lesser of (i) the total amount of OID or (ii) the product of the “total return” on the AHYDO and a fraction whose numerator is the “disqualified yield” and whose denominator is the YTM of the obligation. §163(e)(5)(C) • The “total return” on a debt instrument is the sum of the interest and OID payable on the debt instrument • The “disqualified yield” is the excess of the YTM on the debt instrument over the AFR plus 6%. §163(e)(5)(C) • The disqualified portion may qualify as a dividend to corporate holders of the AHYDO. §163(e)(5)(B) defines the dividend equivalent portion as the portion that would have been a dividend if it had been distributed 16
17. Disqualified Debt Instruments §163(l) 17
18. History of §163(l) • Enacted in 1997, §163(l) denies an interest deduction on any debt of a corporation issued after June 8, 1997 that is payable in equity of the issuer or of a related party. It was broadened in 2004 to include stock owned by the issuer (i.e., portfolio stock) • Congress was concerned “that corporate taxpayers may issue instruments denominated as debt but that more closely resemble equity transactions for which an interest deduction is not appropriate.” H.R. REP. NO. 105-148 at 457 (1997) • The problem that led to the enactment was a class of liabilities that allowed the issuer to pay some or all of its obligation by transferring a fixed number of shares rather than a fixed dollar amount. In such cases, the obligations “more closely resemble equity” because the holders have placed their capital at the risk of the business – if the issuer's stock declines in value, the holders suffer proportionately, even to the point of losing any creditor’s rights in the event of a total failure of the issuer’s business 18
19. “Disqualified Debt Instrument” • §163(l) is only relevant for instruments classified as indebtedness, because if the instrument constitutes “equity,” then no deduction is allowed because the payments would be distributions and possibly dividends • §163(l)(1) provides that no deduction is allowed for any interest paid or accrued on a “disqualified debt instrument” • A disqualified debt instrument is defined as any indebtedness of a corporation which is payable in equity of the issuer or a related party, or in equity held by the issuer (or any related party). §163(l)(2) • §163(l) was expanded by the 2004 JOBS Act, effective for debt issued after October 3, 2004, to apply to debt payable in (or determined by reference to the value of) equity held by the issuer (or any related party) 19
20. DDI – “Payable in Equity” • A substantial amount of principal or interest is required to be paid or, at the option of the issuer or a related party, is payable in equity of the issuer or a related party • A similar rule applies if the principal or interest on the debt is determined by reference to the value of the issuer’s equity, either mandatorily or at the issuer’s option. §163(l)(3)(A) & (B) • Amounts payable in the issuer stock at the holder’s option are not treated as mandatorily payable unless the option is substantially certain to be exercised – Excludes typical convertible debt where the conversion feature is significantly out of the money at issuance 20
21. Disqualified Debt Instrument (cont’d) • The debt is part of an arrangement that is reasonably expected to result in payment of the debt with or by reference to the stock. §163(l)(3)(C) • Examples: – Forward contract issued with debt – Nonrecourse debt secured principally by issuer stock – Debt convertible at the option of the holder if there is a “substantial certainty” of exercise upon issuance 21
22. Convertible Debt • The legislative history states that §163(l) is not expected to affect debt that is convertible at the holder’s option and where the conversion price is significantly higher than the market price of the stock on the issue date of the debt • If, however, the conversion right is deep-in-the-money at issuance, the instrument might well be treated as one that was reasonably expected to result in a conversion • Also, if the holder is related to the issuer, the conversion right could be viewed as causing §163(l) to apply because the stock is convertible at the option of a party related to the issuer 22
23. Consequence of Being a DDI • No deduction is allowed for interest paid or accrued on a disqualified debt instrument • Disallowance applies to both OID and QSI • This is a permanent disallowance rather than deferral • No effect on the classification of the instrument as debt or equity • If the underlying equity is held by a related party, then the basis of the equity held by the related party is increased by the amount of disallowed interest. §163(l)(4) 23
24. P.L. 115-97 (Tax Cuts and Jobs Act) Selected Provisions Impacting Interest Deductions 24
25. Background • On December 22, 2017, President Trump signed H.R. 1, originally known as the Tax Cuts and Jobs Act, into law as Public Law 115-97 • The TCJA represents the most significant revision of the Internal Revenue Code since 1986 • The legislative process from introduction of the bill in the House on November 2, 2017 to passage took less than two months • The TCJA includes numerous uncertainties, issues on which technical corrections may be necessary/desirable, and issues left to be addressed through regulatory or other guidance • Treasury and the IRS have issued numerous sets of regulations, and continue to work to put out guidance 25
26. Interest Deductibility §163(j) 26
27. Interest Deductibility • Annual business expense interest deduction is limited to the sum of the following: (i) business interest income + (ii) 30% of Adjusted Taxable Income (“ATI”) + (iii) floor plan financing interest (i.e., interest paid to finance the acquisition of certain motor vehicles) • ATI generally is as follows: – Similar to EBITDA for taxable years beginning after December 31, 2017, and before January 1, 2022 – Similar to EBIT thereafter BUT based on tax amounts so may diverge from book EBITDA/EBIT • Disallowed interest expense may be carried forward indefinitely – For corporations, subject to §382 in the case of a change in ownership – Excess limitation may not be carried forward • Exemptions for certain categories of taxpayers: – Certain public utilities, floor plan financing indebtedness, and taxpayers with average annual gross receipts not exceeding $25 million – At election of taxpayer – real estate businesses and farming businesses • Applies to business interest only; investment interest remains subject to existing rules • Applies to taxable years beginning after December 31, 2017; no grandfathering for pre-existing debt 27
28. Limitations for Partnerships • 30% limitation is determined at the partnership level – ATI and business interest are both calculated at the partnership level – Business interest deductions allowable are taken into account in determining the non- separately stated taxable income or loss of the partnership – Unused limitation at the partnership level is effectively allocated to the partners who can use it in computing the amount of business interest they can deduct at the partner level – Partner’s distributive share of partnership items is ignored in determining partner-level ATI to prevent “double-counting” the partnership income or loss that determined deductibility at the partnership level – Interest disallowed at the partnership level is passed through to the partners and deductible in future years when they are allocated excess TI from the partnership • Entity-by-entity approach • Basis adjustments for passed through amounts • §163(j) does not apply to §707(c) guaranteed payments (not dependent on partnership income), which are deductible under §162, or to preferred returns (dependent on partnership income), which are not taxable (assuming it does not exceed the partner’s basis in its partnership interest) 28
29. Proposed Regulations • Notice 2018-28 (April 2, 2018) announced interim guidance that taxpayers can rely upon until proposed regulations are issued under §163(j) • Proposed Regulations were issued on November 26, 2018. • Proposed Regulations – – 439 pages in length – Contain 11 proposed sections – Contain more than 80 examples – Contain more than 60 requests for comment – Introduced new IRS Form 8990, released on October 29, 2018 • Expansive definition of interest, even including investment interest as business interest in the case of corporations. See Prop. Reg. §1.163(j)-4(b)(1) 29
30. Debt Modifications 30
31. History • Under Reg. §1.1001-1(a), gain or loss is realized upon the exchange of property for other property “different materially either in kind or in extent” • The IRS had taken the position that changes in the terms of an existing debt instrument may be so material as to amount “virtually” to the issuance of a new debt instrument, and that the same tax consequences should follow “as if” a new debt instrument were actually exchanged for the old debt instrument • Before the issuance of Reg. §1.1001-3, in 1996, it was unclear what changes in an existing debt instrument were so material as to amount to a deemed exchange 31
32. Cottage Savings • In Cottage Savings Assn. v. Commissioner, 499 U.S. 554 (1991), two S&L institutions exchanged economically equivalent bundles of mortgages, which the IRS contended did not give rise to realized losses because the economic characteristics of the two bundles were the same. The Supreme Court rejected the IRS argument, holding that for an exchange of properties to be taxable, the properties need only represent different property rights, and that properties are “different” to a “material” extent under Reg. § 1.1001-1(a) “so long as their respective possessors enjoy legal entitlements that are different in kind or extent” • Taxpayers expressed concern that the Court may have put in place a new “hair-trigger” threshold for when a modification of a debt instrument by an issuer and a holder gives rise to a deemed exchange 32
33. Reg. §1.1001-3 • In response to Cottage Savings and in an effort to provide greater certainty, the IRS in December 1992 issued proposed regulations under §1001 to clarify when a modification of a debt instrument will give rise to a deemed exchange • On June 25, 1996, the IRS issued final Reg. §1.1001-3 relating to the modification of debt instruments. In many cases, the regulations provide clear guidance as to when a modification of the terms of a debt instrument is of such significance that it rises to the level of a deemed exchange 33
34. Scope of Reg. §1.1001-3 • The regulations apply to any modification of a debt instrument, regardless of the form of the modification – Thus, the regulations apply to actual exchanges of an existing debt instrument for a new instrument, and to amendments of existing debt instruments. Reg. §1.1001-3(a)(1) • However, the regulations do not apply to exchanges of debt instruments between holders 34
35. Overview • The regulations provide a two-tier test to determine whether there has been a taxable, deemed exchange of a debt instrument: – Any alteration to the terms of a debt instrument must be tested to determine if a “modification” of the debt instrument has occurred; and – If a modification has occurred, then it must then be tested to determine whether it is a “significant” modification • A “significant modification” results in an taxable exchange of the original debt instrument for a modified debt instrument that differs materially either in kind or in extent • A modification that is not a “significant modification” is not an exchange for purposes of Reg. §1.1001-1(a) 35
36. Modifications • A “modification” is defined broadly to include any alteration (including additions or deletions) to the legal rights or obligations of the holder or issuer of the debt instrument, whether evidenced by an express agreement (oral or written), the conduct of the parties, or otherwise. Reg. §1.1001-3(c)(1)(i) 36
37. Alterations by Terms of Contract • Alterations occurring by operation of the terms of a debt instrument generally are not considered modifications, even if they occur automatically or as a result of the exercise of a holder or issuer option to change a term of a debt instrument • Alterations that are considered modifications, even if they occur by operation of the terms of a debt instrument, include the following: (Reg. §1.1001-3(c)(2)) – Substitution of a new obligor, an addition or deletion of a co-obligor, or a change in the recourse nature of the debt; – Alterations that results in an instrument that is not debt, other than a holder’s option to convert a convertible debt to equity; and – Alterations arising from the exercise of an issuer or holder option, unless the option is “unilateral” and in the case of a holder option, the exercise of the option does not result in deferral of, or a reduction in, any scheduled payment of interest or principal • Unilateral if at the time of exercise, or as a result of exercise, the other party has no right to alter or terminate the instrument or put the instrument to a person who is related to the issuer; • Unilateral if the exercise does not require the consent or approval of the other party, a person related to the other party, or a court or arbitrator; and • Unilateral if the exercise does not requires consideration unless, on the issue date of the instrument, such consideration is a de minimis amount, a specified amount, or an amount based on a formula that uses objective financial information 37
38. Failure to Perform • A failure by the issuer to perform its obligations under a debt instrument generally is not a modification • A holder’s temporarily stay of collection or waiver of an acceleration clause or other default right generally is not a modification, unless the forbearance or waiver remains in effect more than two years from the issuer’s initial failure to perform plus any additional time during which the parties are engaged in good faith negotiations regarding the debt or during which the issuer is in a Title 11 (bankruptcy) or similar case. Reg. §1.1001-3(c)(4) 38
39. Failure to Exercise an Option • If a party to a debt instrument has an option to change a term of an instrument, then the failure of the party to exercise that option is not a modification. Reg. §1.1001- 3(c)(5) 39
40. Time of Modification • An agreement to change a term of a debt instrument is a modification at the time the parties enter into the agreement, even if the change is not immediately effective. Reg. §1.1001-3(c)(6) – Exception: If the parties condition a change in the terms of a debt instrument on reasonable closing conditions (e.g., shareholder approval), then a modification occurs on the closing date of the agreement – There is a similar exception for changes that are conditioned on the acceptance of a plan of reorganization in a Title 11 or similar case • If the reasonable closing conditions (or plan of reorganization) do not occur so that the change does not become effective, then there is no modification 40
41. When is a Modification “Significant”? • Generally, a modification is significant only if, based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant. Reg. §1.1001-3(e)(1) • In addition, the regulations provide 5 specific rules for determining whether certain modifications are significant. Reg. §1.1001-3(e)(2) – (6) • In applying the general facts and circumstances test (i.e., when none of the 5 specific rules apply), all modifications to the debt instrument are considered collectively (other than modifications tested under one of the 5 specific rules) 41
42. 1. Change in Yield • A change in yield results in a significant modification of a debt instrument if the annual yield of the modified instrument differs from the annual yield on the unmodified instrument (from the date of modification) by more than the greater of: (i) 25 basis points or (ii) 5% of the annual yield of the unmodified instrument. Reg. §1.1001-3(e)(2) • Applies only to debt with fixed payments, debt with known alternate payment schedules, debt that provides a fixed yield (such as certain demand loans), and VRDIs, but not to CPDIs • Special yield rule for VRDIs. Reg. §1.1001-3(e)(2)(iv) 42
43. 2. Change in Timing of Payments • A change in the timing of payments (including a resulting change in amount) is a significant modification if it results in a material deferral of scheduled payments. Reg. §1.1001-3(e)(3) – Deferral can be through an extension of the final maturity date or through a deferral of payments due prior to maturity – Materiality depends on the facts and circumstances, including the length of deferral, the original term of the debt, the amounts deferred, and the time period between the modification and the actual deferral of payments • Safe Harbor: extension of payments is not a significant modification if the deferred payments are unconditionally payable no later than the lesser of (i) 5 years or (ii) ½ of the original term of the debt • If outside safe harbor, then not a per se significant modification, but likely would be under the general rule of economic significance • Heading covers all changes in timing, but regulation deals only with extensions. Not clear if all accelerations are per se not significant modifications or must be tested under the general rule of economic significance 43
44. 3. Change in Obligor • Generally, a change in obligor on a recourse debt is a significant modification, except: – a change in obligor as a result of a §381(a) transaction and the transaction does not result in a “a change in payment expectations” or a “significant alteration”; (Reg. §1.1001-3(e)(4)) – a change in obligor as a result of an asset acquisition where the new obligor acquires substantially all of the assets of the original obligor and the transaction does not result in a “a change in payment expectations” or a “significant alteration”; – substitution of a new obligor on a tax-exempt bond, provided the new obligor is related to the original obligor and the collateral securing the bond continues to include the original collateral; – a change in obligor as a result of a §338 election following a qualified stock purchase of the issuer’s stock; – the filing of a petition in a Title 11 or similar case 44
45. Change in Obligor (cont’d) • A change in obligor on a nonrecourse debt is not a significant modification – Does a nonrecourse obligation even have an “obligor”? • Addition or deletion of a co-obligor is a significant modification if it results in a change in payment expectations – If the addition or deletion of a co-obligor is part of a series of transactions that results in the substitution of a new obligor, then the general rule in Reg. §1.1001-3(e)(4)(i) applies over this rule 45
46. Change in Obligor (cont’d) • A “change in payment expectations” occurs if, as a result of a transaction: – there is a substantial enhancement of the obligor’s capacity to meet the payment obligations under a debt and that capacity was primarily speculative before the modification and is adequate after the modification; or – there is a substantial impairment of the obligor’s capacity to meet the payment obligations under a debt and that capacity was adequate before the modification and is primarily speculative after the modification. Reg. §1.1001-3(e)(4)(vi) • A “significant alteration” is an alteration that would be a significant modification but for the fact that the alteration occurs by operation of the terms of the instrument. Reg. §1.1001-3(e)(4)(i)(E) 46
47. Change in Security/Credit Enhancement • For recourse instruments, a change in security or credit enhancement is a significant modification only if there is a “change in payment expectations.” Reg. §1.1001-3(e)(4)(iv)(A) • For nonrecourse instruments, any modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral, guarantee, or other form of credit enhancement is a significant modification. Reg. §1.1001-3(e)(4)(iv)(B) • A change in the priority of a debt instrument relative to other debt of the issuer is a significant modification if it results in a “change in payment expectations.” Reg. §1.1001-3(e)(4)(v) 47
48. 4. Changes in the Nature of a Debt Instrument • A modification of a debt that results in an instrument or property right that is not debt for federal income tax purposes is a significant modification. Reg. §1.1001-3(e)(5)(i) • A change in the nature of a debt from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), or vice versa, is a significant modification – Legal defeasance (i.e., release) of obligor is a significant modification – Exception for defeasance of tax-exempt bonds • Original Collateral Exception. A modification that changes a nonrecourse debt to a recourse debt is not a significant modification if the instrument continues to be secured by the original collateral and there is no change in payment expectations 48
49. 5. Accounting or Financial Covenants • A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification. Reg. §1.1001-3(e)(6) – For example, leverage ratios or other financial metrics 49
50. Rules of Application • Modifications are tested under the 5 specific rules first, and if the modification is not addressed in those rules, then under the general rule of economic significance in Reg. §1.1001-3(e)(1) – For example, a deferral of payments that changes the yield of a fixed rate debt must be tested under Reg. §1.1001-3(e)(2) & (3) • If a modification described in paragraphs (e)(2) through (e)(5) is effective only upon the occurrence of a substantial contingency, then the significance of the modification is tested under the general rule of economic significance in Reg. §1.1001-3(e)(1) rather than under paragraphs (e)(2) through (e)(5) • If a modification described in paragraphs (e)(4) and (5) is effective only on a substantially deferred basis, then the significance of the modification is tested under the general rule of economic significance in Reg. §1.1001-3(e)(1) rather than under paragraphs (e)(4) and (5) 50
51. Rules of Application (cont’d) • 2 or more modifications that occur over any period of time constitute a significant modification if they had been done as a single change and such change would have resulted in a significant modification. Reg. §1.1001-3(f)(3) – For changes in yield under (e)(2) – disregard prior modifications occurring more than 5 years before the date of the modification being tested • Modifications of different terms of a debt, none of which separately would be a significant modification, do not collectively constitute a significant modification. Reg. §1.1001-3(f)(4) 51
52. Consequences of a Significant Modification • Gain or loss recognition by the issuer or holder • The debt will have to be re-tested to determine whether it is debt or equity • A debt instrument that was not originally an OID instrument may become an OID instrument after the modification • The debt needs to be re-tested under the AHYDO rules • New identifications may be necessary for mark-to-market tax accounting purposes, hedging purposes, or integration purposes • Banks may need to address whether a bad debt charge-off of the “new” loan is appropriate after the modification • Relationships with borrowers may be affected if information reporting is required for any cancellation of indebtedness income that may arise 52
53. LIBOR Transition Guidance 53
54. LIBOR Phase-Out Regulations • The London Interbank Offered Rate (“LIBOR”) is the most often used benchmark for floating-rate debt that is denominated in the US Dollars, as well as for a wide range of financial products (e.g., swaps, forwards) • In the wake of rate-setting scandals involving numerous banks, the organizations sponsoring LIBOR determined that they would phase it out • Central banks and financial regulatory working groups around the globe have done extensive work to encourage a transition to a different uniform benchmark rate 54
55. What are the stakes from a tax perspective? • LIBOR covers approximately ¼ quadrillion dollars (or $250 trillion) of financial products • A change to the terms of a financial product to replace LIBOR with another rate generally must be tested under §1001 – If debt, then the Cottage Savings regulations apply (Reg. §1.1001-3) – If a non-debt contract, then Reg. §1.1001-1(a) applies (property differing materially in kind or extent) 55
56. IBOR Regs • January 4, 2022 – IRS issued final regulations, which generally adopt the regulations proposed in October 2019, with some modifications • Reg. §1.1001-6 provides guidance with respect to alterations to debt instruments, derivative contracts, and other contracts that replace interbank offered rates (IBORs) with qualified replacement rates or provide fallback replacement rate provisions • There are also amendments to other regulations addressing integrated transactions, foreign banks, REMICs, and VRDIs • Rules apply equally to modifications and to exchanges 56
57. IBOR Regs (cont’d) • Provide detailed requirements to prevent a LIBOR replacement from constituting a taxable event under §1001 • Apply to debt instruments and non-debt instruments • Address the effect of replacing the rate and the tax treatment of any associated payments (i.e., yield spread or one-time payment) 57
58. Sales, Exchanges, and Redemptions 58
59. Holder’s Treatment • Upon the sale or exchange (including a deemed sale or exchange by virtue of retirement or redemption) of a debt instrument, the holder’s gain/loss equals the difference between the amount realized and the adjusted basis of the debt • The amount realized equals the sum of any money received plus the FMV of any property received • A redemption of a debt instrument, with some limited exceptions, is treated as a sale or exchange of the instrument. §1271(a)(1) • If the debt instrument is held as a capital asset, the character of the gain or loss generally is capital 59
60. Character Issues: Are Loans Capital Assets? • The fact that an investment fund is engaged in a business of buying distressed loans does not necessarily result in the loans being treated as ordinary assets • Since the Supreme Court’s Arkansas Best decision in 1988, property is treated as a capital asset unless a statutory provision makes it ordinary. Obligations held in inventory or for sale primarily to customers in the ordinary course of business, e.g., by a securities dealer, are not capital assets because they are described in §1221(a)(1) • Burbank Liquidating Corp. v. Commissioner is authority for the proposition that obligations issued and held by a lender in the ordinary course of its business are not capital assets because they are “notes receivable acquired . . . for services rendered” (namely, making loans), and so are ordinary assets under §1221(a)(4) • Under §475(f), securities traders can elect mark-to-market treatment and recognize ordinary gain and loss on their ”securities” (including debt instruments), with an exception for securities not held in connection with the business of being a securities trader 60
61. Exceptions: Ordinary Income • To the extent of accrued interest not previously includible in income. Reg. §1.61-7(d) • To the extent the market discount rules require the recognition of ordinary income. §1276 • If there was an intention to call before maturity, to the extent of the unaccrued OID. §1271(a)(2)(A) • With respect to short-term, taxable government obligations, to the extent of gain realized not in excess of the holder’s “ratable share” of “acquisition discount.” §1271(a)(3) • With respect to short-term, taxable non-government obligations, to the extent of gain realized not in excess of the holder’s “ratable share” of OID. §1271(a)(4) • To the extent of any gain realized on a registration- required obligation that is not in registered form. §1287(a) 61