Yoram Keinan Taxation of Financial Instruments

Class 8

Transcript

1. Where do Changes in Law come from?
2. What drives changes in tax treatment of financial transactions? • Financial transactions and instruments are extremely adaptable, partly because the area is subject to less regulation. • Three main “players” • Issuers of financial instruments. • Buyers of financial instruments. • Intermediaries. • All it takes is some smart people and some money.
3. Example: Original Issue Discount • Before 1969, there was no accrual of OID, but gain on sale was ordinary income to the extent of OID. • In 1969, the law was changed to provide ratable (straight line) accrual of OID. • In the late 1970’s, inflation raged. To bring inflation down, the Federal Reserve raised interest rates, leading to increased borrowing costs for corporate issuers.
4. Example: Original Issue Discount • Issuing zero coupon or deeply discounted bonds provided big savings for issuers – a 15% ten year zero coupon bond had a pre-tax equivalent cost of about 14% because of the difference between constant rate accrual of OID and straight line accrual. • Who would buy the bonds? • Result – starting in 1982, time value of money concepts applied to debt instruments by Congress.
5. Interest Rate Swaps • Developed in the early 1980s, interest rate swaps raised many questions as to tax treatment – timing, character, source. • Manipulating interest rate swaps was relatively easy; as the market grew, there was a known “swap curve” and a unique discount rate for a cash flow at any given future point. • A swap dealer could therefore fashion swaps with significant nonperiodic payments.
6. Single payment interest rate swaps • Taking nonperiodic payments to the extreme, intermediaries realized that they could fashion an interest rate swap in which all of the fixed payments were made at once, while the floating payments were made over time. • How was the up-front payment to be characterized? • Income? • Loan? • Fixed leg, to be amortized over the life of the swap?
7. Single Payment Interest Rate Swaps • Renewing net operating losses. • Creating foreign source income. • Repatriating foreign cash. • Making capital gain disappear.
8. Income up-front? • In the late 1980s, it was unclear how an upfront payment on a swap was treated. • Tax lawyers and others looked at American Automobile Assoc. v. United States, 367 U.S. 687 (1961) and Schlude v. Commissioner, 372 U.S. 128 (1963) and advised that all of the payment must be taken into income. • Useful for loss companies with expiring nol’s; might generated foreign source income for companies with excess credits. • Treasury response: Notice 89-21 and Treas. Reg. § 1.446-3.
9. Turn Notice 89-21 on its head • US multinational has Swiss subsidiary with substantial cash amounts. • In order to avoid taxation under section 956, which treats a loan from a foreign subsidiary to a domestic parent as a taxable dividend, US MNC entered into an interest rate swap with a foreign bank. • US MNC then sold its right to receive payments on the swap to Swiss subsidiary. • Under Notice 89-21, US MNC said that it spread the income from selling its “receive” leg over the life of the swap – and it was not an ”investment in US property” taxable under section 956.
10. Result: Treatment Rejected • IRS treated payments from Swiss sub to US MNC as loans, not sales, and assessed tax. • US MNC sued for refund. • US MNC lost in District Court and on Appeal: • Schering-Plough Corp. v. U.S., [cite] (DC NJ 2009). • Merck v. U.S., 652 F.3d 475 (3rd Cir. 2011). • Decided under substance over form principles. • How would transaction have been treated under Treas. Reg. § 1.446-3?
11. One more try • What if you accepted that a single payment interest rate swap was debt? • Form a partnership with non-tax sensitive partner (foreign) and purchase property. • Partnership sells property in exchange for cash and “LIBOR note” (interest rate swap with fixed leg paid up- front, so only flows are LIBOR on notional principal amount). • Under installment sale regulations, basis of sale to be allocated ratably over life of contingent note. • Result: Large capital gain in first year (allocated mostly to foreign partner), capital losses in later years (allocated to US partner after foreign partner redeemed out of transaction).
12. Result: economic substance doctrine • ACM Partnership v. Commissioner, 157 F.3d 231 (3rd Cir. 1998). • Saba Partnership v. Commissioner, 273 F.3d 1135 (DC Cir. 2001). • ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (DC Cir 2000). • Boca Investerings Partnership v. Commissioner, 314 F.3d 625 (DC Cir 2003). • Code section 7701(o).
13. What drove the tax law? • Established tax treatment did not fit economics (OID). • New financial product with no agreed tax treatment. • Reasoning by analogy. • Market realities. • Desire to solve tax problems. • Intermediaries with tax lawyers aplenty.
14. What drove the tax law? • Congress responds. • IRS responds with audit. • IRS responds with notice followed by rulemaking. • Courts make law. • Which result is preferable? • Compare specific fixes and general anti-abuse rules.
15. LIBOR Transition Guidance 15
16. 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 16
17. 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) 17
18. Proposed Regs (Oct. 2019) • Prop. Reg. §1.1001-6 addresses whether and when a §1001 event occurs upon a replacement of LIBOR with a different rate • There are also proposed amendments to other regulations addressing integrated transactions, foreign banks, REMICs, and VRDIs • Rules apply equally to modifications and exchanges • Rules apply prospectively – to modifications/exchanges that occur after the regs are finalized, but taxpayers can rely on them before then if they act consistently 18
19. Proposed 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) 19
20. Proposed Regs (cont’d) • If a financial instrument referencing any interbank offer rate (an “IBOR”) replaces that rate with a “qualified rate,” then • For a debt instrument, the alteration (and any “associated alteration”) is not treated a modification under Reg. §1.1001-3 • For a non-debt instrument (including stock), the alteration is not treated as property exchanged for other property that differs materially in terms of kind or extent (See Reg. §1.1001-1(a)) • Thus, replacing an IBOR with a “qualified rate” is not a taxable exchange • One-time payments have the same “source and character” as other payments under the financial instrument • Preamble states that financial instruments that otherwise benefit from various grandfathering provisions are not intended to be treated as reissued 20
21. Proposed Regs (cont’d) • There are 3 requirements for a “qualified rate”: • Rate Test: The rate either must be one of eight specifically enumerated rates (including SOFR) or fall into one of 4 other rate categories: • Any alternative, substitute or successor rate selected, endorsed or recommended by the central bank or monetary authority as a replacement for an IBOR or its local currency equivalent in that jurisdiction; • Any other “qualified floating rate” as defined in the existing regulations relating to VRDIs, without regard to the limitation on multiples; • Any rate determined by reference to the above rates, including by adding or subtracting basis points to the rate or by multiplying the rate by a specified number; or • Any rate published as a “qualified rate” in the IRB • FMV Test: The FMV of the debt instrument after the rate replacement must be substantially equivalent to the FMV of the debt instrument before the rate replacement; and • 2 safe harbors – (i) an objective one, based on comparing the historic averages of the IBOR and replacement rates, and (ii) one based on unrelated parties engaging in bona fide arm’s-length negotiations • Reference Currency Test: The new rate must be benchmarked to transactions in the same currency as the old rate 21
22. Proposed Regs – Other Issues • Provide protection against deemed “legging out” of integrated transactions, nonfunctional currency rules, and hedge accounting rules • Intended to allow integrated transactions to preserve their integrated character after transition, avoiding timing and character mismatches • Protection against certain VRDIs being treated as retired and reissued, or being subject to the CPDI rules • This rule is very helpful to taxpayers and may reflect a policy approach that is consistent with the central banks views that adoption of a new benchmark should be voluntary and market- driven 22
23. Proposed Regs – Other Issues (cont’d) • Alterations that are necessary to implement the qualified rate that are associated with and reasonably necessary – including any one-time payment – do not cause a deemed exchange • An ordering rule provides that the replacement rate is deemed to be implemented before other alterations that might have to be determined separately (e.g., rate adjustments to reflect an unrelated credit deterioration of a counterparty) 23
24. Proposed Regs – Some Open Issues • What financial instruments are covered by the proposed regs? Preamble indicates scope to include debt instruments, derivatives, stock, insurance contracts, and lease agreements • Given the existence of §368(a)(1)(E), why is stock in scope? • What about a preferred partnership interests that might reference an IBOR? • One time adjustment payments retain the “source and character” of a payment on the post-replacement instrument • Portfolio interest? Dividend? Rental income? • Instruments with multiple cash flows? • Can the rules be used as a shield to hide other potentially taxable transactions? 24
25. Proposed Anti-Hybrid Regulations under Sections 267A, 245A, and 1503(d)
26. Overview • On December 20, 2018, the IRS released proposed “anti-hybrid” regulations under sections 267A, 245A(e), and 1503(d). • Sections 267A and 245A(e) were enacted in 2017 as part of the tax reform act. Very generally, these sections deny U.S. tax deductions associated with a financial instrument, transaction, or entity that is treated differently under the tax laws of the US and the tax laws of another country. • Such an instrument, transaction, or entity is referred to as a “hybrid”; and sections 267A and 245A(e) are referred to as “anti-hybrid” provisions. • Hybrids, by exploiting the differences between tax laws, can be used to claim tax benefits in multiple countries or achieve “double nontaxation”. • The Proposed Regulations will generally be retroactively effective from January 1, 2018 if they are finalized by June 22, 2019. If they are not finalized by then, they will be effective as of December 20, 2018.
27. Section 267A • Section 267A generally denies a deduction for any “disqualified related party amount” paid or accrued pursuant to a hybrid transaction or paid or accrued either by or to a hybrid entity. • A “disqualified related party amount” is any interest or royalty that is paid or accrued to a related party if either (i) the amount is not included in the income of the related party under the tax law of the country of which the related party is a resident for tax purposes or is subject to tax, or (ii) the related party is allowed a deduction with respect to that amount under the tax law of that country. • A disqualified related party amount does not include any payment to the extent that the payment is included in the gross income of a US shareholder as subpart F income under section 952 or as an investment in U.S. property under section 956.
28. Hybrid Transaction • A hybrid transaction is a transaction that gives rise to interest or royalties for U.S. federal tax purposes but is not so treated under the tax laws of the foreign recipient. • A hybrid entity is one that is treated as “fiscally transparent” in the US or another jurisdiction, but as a taxable entity in the other. • Fiscally transparent generally means that the owners or investors of an entity are taxed on the income earned by the entity rather than the entity itself. • The income earned by the entity is not subject to tax at the entity level, but rather flows or passes through to its owners or investors.
29. Sections 245A(e) and 1503(d) • Section 245A(e) denies the dividends-received deduction under section 245A(a) for “hybrid dividends”. • Section 245A(e) also requires that any hybrid dividend received by a CFC from a lower-tier CFC (a “tiered hybrid dividend”) be treated as subpart F income and included in the gross income of a U.S. shareholder. • Any foreign tax credits or foreign tax deductions associated with hybrid dividends or tiered hybrid dividends are also disallowed. • Section 1503(d) generally prevents a corporation that is a tax resident of the US and another jurisdiction from using a single economic loss to generate deductions that offset income in both jurisdictions.
30. Coordination with BEPS/OECD • The OECD previously addressed the international tax arbitrage opportunities presented by hybrid transactions and hybrid entities in its proposals under Action 2 of the OECD’s Base Erosion and Profit Shifting (“BEPS”) project. • Section 267A grants Treasury broad authority to issue regulations, and the legislative history to section 267A indicates that the section was intended to be consistent with “many of the approaches to the same or similar problems” taken in the BEPS project, bilateral income tax treaties, and provisions or rules of other countries. • The Joint Committee on Taxation’s “Blue Book” describing the tax reform act indicates that Treasury’s regulatory authority properly extends to addressing the “overly broad or under-inclusive application” of section 267A.
31. Summary of the Proposed Regulations
32. Proposed Regulations • Limit disallowance under section 267A to (i) a tax resident of the US, (ii) a CFC for which there is one or more 10% US shareholders, and (iii) a U.S. taxable branch. • Adopt a very broad definition of interest (corresponding to the very broad definition in the section 163(j) proposed regulations). • Expand the scope of section 267A to apply to payments to reverse hybrids as well as to timing mismatches of more than 36 months. • Provide information and reporting requirements for transactions that result in a disallowance under sections 245A and 267A. • Extend the application of the existing dual consolidated loss rules under section 1503(d) to domestic reverse hybrid entities.
33. Proposed Regulations • The Proposed Regulations dramatically expand the scope of section 267A beyond the statutory language, based on the broad grant of regulatory authority. • If the Proposed Regulations are finalized as proposed, they will represent a reversal of over twenty years of U.S. tax policy that has facilitated cross-border tax arbitrage since the “check-the-box regulations” were finalized in 1996. • The Proposed Regulations would effectively prevent much of the arbitrage that the check-the-box regulations permit.
34. Proposed Regulations • The Proposed Regulations do not address all cross-border arbitrage. They limit disallowance under section 267A to (i) deductions for interest and royalty payments to related parties and (ii) arrangements with an unrelated party where the arbitrage is priced into the terms of the arrangement or, the arbitrage is a principal purpose of the arrangement (“structured arrangements”).
35. Proposed Regulations • The Proposed Regulations apply to payments that produce a deduction under U.S. tax law, but no corresponding income inclusion under foreign tax law (referred to as a “deduction/no-inclusion” or “D/NI” outcome). • However, disallowance under section 267A must result from the hybrid nature of a transaction or arrangement. Section 267A does not disallow a deduction if the deduction/no- inclusion outcome is the result of a feature of foreign tax law unrelated to the hybrid nature of the transaction or arrangement, such as a jurisdiction that does not impose an income tax.
36. Hybrid Dividends • Under the Proposed Regulations, a hybrid dividend is a dividend that is otherwise eligible for the section 245A 100% dividend-received deduction, but for which the CFC is or was allowed a “hybrid deduction”. • A hybrid deduction is a deduction or other tax benefit allowed under a “relevant foreign tax law” that relates to an amount paid, accrued or distributed with respect to an instrument that is issued by a CFC and treated as equity for U.S. tax purposes. • This deduction gives rise to a deduction/no-inclusion outcome because the CFC is entitled to a deduction under relevant foreign tax law, but absent section 245A(e), would not be taxable by the United States (by reason of the 100% dividends-received deduction).
37. Examples of Hybrid Deductions • A hybrid deduction arises if an equity investment in a CFC is treated as debt in the CFC’s resident country (thus giving rise to an interest deduction) and as equity in the US. • If the foreign country has hybrid mismatch rules that deny a deduction for payments on a hybrid instrument in order to prevent a deduction/no-inclusion outcome, there is no hybrid deduction (and therefore the 100% dividends-received deduction would be permitted) because the deduction is not “allowed.” • A deduction or other tax benefit is treated as a hybrid deduction only if it relates to a payment on an instrument of the CFC that is treated as stock for U.S. tax purposes.
38. Reporting Requirements • The Proposed Regulations require taxpayers to report specified payments for which a deduction is disallowed under section 267A and hybrid dividends under section 245A(e) in accordance with sections 6038 and 6038A. • Taxpayers are required to report this information on the appropriate reporting forms for accounting periods or tax years beginning after December 20, 2018. • For hybrid dividends under section 245A(e), a CFC paying the dividends must report such dividends on Form 5471. • For specified payments under section 267A, the reporting requirements depend on the tax characteristics of the party making the payment. • If the payor is a CFC, then it must report the specified payment on Form 5471. • If the payor is a 25% foreign-owned U.S. corporation, then the information is reported on Form 5472. • If the payor is a controlled foreign partnership, the controlling 50% partner must provide the information on Form 8865.
39. Interest Deductibility §163(j) 39
40. 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 40
41. 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) 41
42. 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) 42