Yoram Keinan Taxation of Financial Instruments

Class 7

Transcript

1. Wall Street Hybrids
2. “Call Spreads” Convertibles with Hedge and Higher Strike Warrants
3. “Call Spreads” • Call spreads were originally designed to take advantage of different tax and accounting treatment. • Three components: – Noncontingent convertible debt, with a conversion price in the typical range for convertibles (up 25-35%); – A call or “note hedge,” purchased from one or more counterparties, which exactly matches the conversion feature of the debt; and – A warrant, sold to the same counterparties, with a higher strike price (up 40-75%) and a slightly longer term (typically 90 days longer). • Taxpayer elects to integrate convertible and note hedge (but not warrants) under Reg. §1.1275-6.
4. Convertible + Hedge and Warrants • Example – – 5-Year convertible sold for $1,000 with conversion price of 130% of current stock price and interest rate of 2 percent – 5-year option with same strike price purchased for $300 – 5-year, 3 month warrant with strike price of 175% sold for $140. • Integration results in taxpayer being treated as having issued a synthetic nonconvertible debt for $700, with $300 of deductible OID. Warrant transaction is not taxable under §1032. • For physically settled convertibles, financial accounting does not separate out conversion right and does not integrate, so $300 is not shown as an interest expense. But for cash-settled convertibles financial accounting requires bifurcation, much like the tax investment unit rules.
5. Call Spreads – Tax Issues • Could the purchased call option and the warrants be treated as a single financial instrument (a “call spread”) and hence prevent separate integration of purchased call? • Can the Commissioner deny integration of the purchased call or force integration of the warrants? • Is the transaction subject to the OID anti-abuse rule? • IRS addressed these issues, and reached a favorable conclusion, in General Legal Advice Memo 2007014.
6. Debt + Forward Contract Investment Units (“Mandatory Convertibles”)
7. Mandatory Convertibles Background • Debt whose principal is fully indexed (up and down) to the issuer’s stock almost certainly would be classified as a form of equity. • Under §163(l), debt whose principal is payable in, or determined by reference to the value of, the stock of the issuer or a related party, is a “disqualified debt instrument,” with the result that interest thereon is not deductible.
8. Mandatory Convertibles (cont’d) • Feline PRIDES (Merrill Lynch), ACES (Goldman Sachs) and Upper DECS (Citigroup) get around these problems by giving investors an investment unit consisting of a debt instrument and a variable forward purchase contract on the issuer’s stock. The principal amount of the debt is equal to the price the issuer will receive for its stock under the forward contract. • If the two components are respected as separate for tax purposes, then the interest on the debt is deductible and any gain or loss on the forward should be nontaxable to the issuer under §1032. A private ruling confirms the applicability of §1032.
9. Mandatory Convertibles (cont’d) • It would be most convenient if the debt matured on the same day as the forward contract. The holder could then use the debt proceeds to satisfy its obligation on the forward and simply receive the stock. • But this looks too much like the parties always intended that the obligations would be netted and there is no real debt. • On the other hand, if the debt matures after the forward contract, the holder has to come up with additional cash to exercise the forward. • Solution: issuer remarkets the debt a few months before the forward contract matures. Interest rate resets to a market rate so the debt will be worth face. Market settled on 3-year forward contract and 5- year debt term, with remarketing 3 months in advance. • On many early deals, remarketings failed because interest rate was subject to a cap (e.g., spread over Treasury yields could not exceed 150 basis points). The caps seemed unlikely to apply when the deals were structured, but when Treasury yield plummeted, corporate yields didn’t drop nearly as much, widening spreads to unprecedented levels. Later deals dropped this feature.
10. Revenue Ruling 2003-97 • In July 2003, IRS ruled that debt/forward contract units would be respected as separate provided four critical factors are present: – Components separable and no economic compulsion not to separate – Upon issuer bankruptcy, forward contract terminates and debt is released to holder – Period debt remains outstanding after forward contract is significant both absolutely and relatively – Remarketing of debt is substantially certain to succeed.
11. Contingent Payment Convertibles
12. Contingent Payment Convertibles • Contingent payment convertibles are just like ordinary convertibles, except that the holder is entitled to an additional interest payments upon the occurrence of a contingency. • Contingency typically relates to the trading price of the convertible (e.g., payable if convertible trades at more than 120% of face). Contingency is designed not to be “remote.” • Amount of contingent interest is designed to be more than an “incidental” amount, but not so large as to be terribly costly (typically 25-50 bps).
13. Intended Tax Treatment • Interest contingency makes the convertible a CPDI, avoiding the general exclusion from CPDI treatment for plain-vanilla convertibles. • Comparable yield is based on a comparable non-convertible fixed rate instrument. • Not limited to AFR if issuer can show a higher borrowing cost by clear and convincing evidence. • Accruals at comparable yield on entire issue price of instrument.
14. IRS Response – Rev. Rul. 2002-31 • The CPDI rules apply as long as the contingent interest is not remote or incidental • The comparable yield is a comparable non- convertible yield • The OID anti-abuse rules do not apply • §163(l) does not disallow interest deductions • §249 does not disallow interest deductions at the comparable yield, but does apply to positive adjustments
15. PHONES
16. PHONES • PHONES were a form of CPDI developed in the late 1990s to allow issuers with appreciated stock to – – Hedge against a decline in the value of the stock without triggering recognition of the gain; – Monetize some of the value of the stock; and – Take advantage of the CPDI rules to accrue interest on a borrowing that could be repaid with stock. • 2004 Act effectively shut down PHONES by expanding §163(l) to include debt payable in stock owned by the issuer of the debt. • Still interesting because of what PHONES teach us about the CPDI rules and debt/equity analysis.
17. PHONES – Typical Terms • Denominated as debt • Issued at price of one share of reference stock on issue date (say $100) • Pays a small current cash yield (1-2%) • Matures in 30 years • At maturity, pays cash equal to the greater of: (1) then value of one share of reference stock or (2) $100 • In simplest terms, PHONES combine: – a fixed-rate debt instrument issued at about $32.45 (at 8% discount) that pays current interest of $2 annually and $100 at maturity, and – a long-term call option written by the issuer for a premium of $67.55 that gives the holder the right to purchase one share of the reference stock at maturity for $100.
18. Are PHONES Debt? ▪ Debt is an unconditional promise to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future. For PHONES, the “sum certain” is 100% of the issue price and the maturity date is 30 years (not unreasonably long). These are terms that are indicative of debt. ▪ Note, however, that the value of the fixed return represents less than one-third of the total value of the PHONES. That would have been a disqualifying factor under the 1980 §385 regulations, but those are gone. ▪ Superficially, the holder has no downside risk on the stock, because the embedded option is “at the money.” But unless the stock appreciates to make up the difference between the stated interest rate and the comparable yield, the investor loses. In fact, PHONES are highly correlated to the underlying stock, both up and down.
19. Straddle Issue • Are the PHONES a “position” with respect to the reference stock? Proposed regulations under §263(g) takes the view that it is, effective 1/17/2001. • Are the PHONES “indebtedness incurred or continued to purchase or carry” personal property which is part of a straddle? Proposed regulations again say yes, but what is current law?
20. PHONES – Constructive Sale • §1259, enacted in 1997, treats certain enumerated transactions as constructive sales for tax purposes. These include short sales, offsetting notional principal contracts and futures or forward contracts. The call option imbedded in the PHONES is not one of these enumerated transactions. • The IRS may issue regulations that treat other transactions as constructive sales if they have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income and gain in the reference stock. These regulations, when issued, are expected to be prospective, except in cases to prevent abuse. • PHONES eliminate much of the risk of ownership of the stock, but perhaps not “substantially all.”
21. Mandatory Exchangeables
22. Mandatory Exchangeables – Base Case Example • Issuer C owns 1 million shares of XYZ Corp, an unrelated corporation. XYZ stock is currently worth $25/share. • C issues debt instruments, each with a face amount of $1,000 and a term of 2 years. Interest is payable at a market rate, say 6 percent. • At maturity, the holder of the debt receives: – 40 shares of XYZ stock, if the price is $25/share or less – $1,000 cash, if the stock price is between $25 and $31.25 – 32 shares of XYZ stock, if the price is above $31.25 • Same formula as used in variable prepaid forward contracts (VPFCs).
23. Mandatory Exchangeables – Basic Tax Issues • Is this instrument – – A CPDI? – A financial instrument that is not debt (a variant of a VPFC)? – A combination of a debt instrument and a forward contract? • Problems with each approach: – No guaranteed return of principal, so not debt under common law. – No applicable guidance, especially for the periodic payments. – Contrary to the law that a single instrument generally is not treated as if it were two and that separate treatment requires legal separability and no economic compulsion to keep the pieces together. • For most issuers, if classified as debt, interest is not deductible under §163(l), as expanded in 2004. Dealers, however, received an exception from the expansion in §163(l)(5).
24. Mandatory Exchangeables – Factual Variations • Holder always has the right to the value of 40 shares, but issuer has the right to call the instrument before maturity. Call price is above face, so investor keeps some upside in reference stock, but not unlimited. • Value of holder’s downside risk outweighs the upside, so the instrument pays “interest” at an above-market rate. For example, issuer has a right to call at par. • Value of upside outweighs the downside, so the instrument pays “interest” at a below-market rate. Note that if no downside, the instrument is like PHONES and is taxed as a CPDI.
25. Mandatory Exchangeables – Issuer Tax Positions • Most likely not CPDIs, because of risk to principal. Not a desirable result because holders would lose long-term capital gain treatment. • No debt component. Periodic payments taxable to holder in full as accrued or received. • Combination of debt and forward contract: – If forward contract has no initial negative value to the investor, which could be inferred if instrument pays “interest” at a market rate, then treatment is easy. Stated interest is treated as interest and investor has gain or loss on the forward contract measured by difference between contract price ($25) and the amount received when the instrument matures (or when issuer exercises its call right).
26. Mandatory Exchangeables – Issuer Tax Positions (cont’d) • If the “interest” rate is above market, implying that the forward contract has an initial negative value, then issuers have taken different approaches: – Debt deemed to have been sold at a premium and issuer to have paid investor for having entered into the off-market forward. – Treat “interest” payments as interest only to the extent of market rate. Treat excess as put option premium paid to investors – open tax treatment until option resolved. – Same as preceding approach, but treat excess “interest” as some sort of contract fee, currently taxable to investors – Treat the entire amount of stated “interest” as interest.
27. Mandatory Exchangeables – Issuer Tax Positions (cont’d) • If the “interest” rate is below market, implying that the forward contract has an initial positive value, then issuers can: – Treat the debt component as having been issued at a discount, requiring holder to accrue OID income (i.e., the investment unit model), or – Respect the form and holder accrues interest only at the stated “interest” rate (i.e., the convertible debt model). • Tax disclosures generally take the first approach, which is more conservative (i.e., holders have greater income). • Issuers generally taxed under §475 mark to market rules because they are dealers.
28. Introduction to U.S. International Tax Treatment of Financial Instruments
29. Statutory Provisions • Sections 871 and 881 set forth the tax rules pertaining to passive income of individuals and corporations, respectively. • Section 871(a) – income of non-US resident individuals not connected with a US trade or business, other than capital gains, is subject to a 30 percent gross tax. • Section 871(b) – income of non-US resident individuals that is connected with a US trade or business is subject to graduated rates of tax on a net basis, similar to the rules that apply to US residents. • Corresponding rules apply for taxpayers other than individuals under section 881.
30. US Source Rules (sections 861 – 865) • The considerations for US residents and non-US residents are not at all similar in terms of their purpose. – For non-US residents, the source rules will determine whether they are taxed in the host country (i.e., the US). – For US residents, it is simply a matter of tax planning. • The US source rules can be divided in two categories: – Formal rules do not try to trace the economic source of the income but seek to achieve administrative ease and certainty. Under the control of the taxpayer (e.g., residency). – Economic rules try to trace the economic source of the income.
31. Withholding • Pursuant to sections 1441 and 1442, US withholding tax will apply to a payment if (i) the payment constitutes a fixed or determinable, annual or periodical amount (“FDAP”), (ii) the payment has a US source, and (iii) the payment is not effectively connected to a US trade or business. • If all three requirements are satisfied, a gross- basis withholding tax of 30% applies, unless the rate is reduced or eliminated by an applicable income tax treaty.
32. FDAP • The definition of FDAP income is very broad and includes various types of income. • The income need not be annual or periodical – a single payment can constitute FDAP. • Certain specific exceptions exist, one of which is for gains from the sale of property, including option premiums. • There is no exception from FDAP income for payments under a NPC.
33. Trade or Business • A non-US person will not be viewed as engaged in a trade or business in the US unless the US activities are "considerable, continuous, and regular." • In the context of tax treaties, the “business profits” of a lender resident in the treaty partner country are only subject to US tax if the lender is doing business through a “permanent establishment” in the US. • In the case of interest income, this standard is not materially different from the trade or business threshold.
34. Effectively Connected Income (“ECI”) • There is no formal definition in the Code. • Section 864(c)(2) provides two tests: – Asset Test: Whether income, gain, or loss is derived from assets used in or held for use in the conduct of a US trade or business. – Material Factor Test: Whether activities of the US trade or business were a material factor in the realization of the income, gain, or loss. • In tax treaties, the concept of ECI is stated as “income attributable to the permanent establishment.” There is likely no difference in meaning.
35. Permanent Establishment (“PE”) • Each treaty has its own definition of “permanent establishment.” • The threshold for a PE may be different than the threshold to establish a trade or business. • Even treaties that follow the U.N. model contain a lower PE threshold than the OECD model. • For example, in the U.N. model, in order for a temporary construction site to constitute a PE, it has to last for more than 6 months; in the OECD model, it has to last for more than 1 year.
36. Cross Border Interest • There are two possible tax regimes for non-US persons receiving interest income: – Non-U.S. persons that are engaged in a “trade or business” (“ETB”) in the US are subject to the regular US net income tax at graduated rates for individuals or corporations, as the case may be, on income that is “effectively connected” with such US trade or business. – Non-U.S. persons that are not ETB, or that derive interest income that is not ECI, are subject to the US withholding tax on gross income.
37. Cross Border Interest (cont’d) • For interest that is not effectively connected with a US trade or business, the maximum withholding tax rate is 30%, unless exempt under the portfolio interest exemption (“PIE”) or otherwise reduced or eliminated by an applicable income tax treaty. • Interest that is ECI is subject to the regular US net income tax at graduated rates.
38. Exception: US Payors with Significant Foreign Activities • Pursuant to section 861(a)(1)(A) and (B), interest paid by a US taxpayer with significant foreign business activities to a foreign person is foreign source interest rather than US source interest, contrary to the general sourcing rule relating to interest.
39. Portfolio Interest Exemption (1984) • US-source interest received by non-US persons is generally not taxed in the US if it qualifies for the “portfolio interest exemption.” • The exemption was enacted “to allow US corporations (and the US Treasury) direct access to the Eurobond market.” • Interest income typically is taxed in residence country, but can be avoided by establishing a company in a tax haven. • Portfolio interest includes is interest and OID on debt: (A) in registered form, provided the relevant withholding agent receives proper certification that the beneficial owner of the obligation is not a US person, and (B) in unregistered (bearer) form, provided that the requirements of section 163(f)(2)(B) are met.
40. Exceptions to PIE • Under section 881(c)(3), portfolio interest generally does not include interest received by: (a) a “10% shareholder” (b) a bank receiving interest on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business; or (c) a CFC from certain related persons. • Certain types of contingent interest do not qualify for the PIE. Sections 881(c)(4) & 871(h)(4).
41. Effectively Connected Interest Income • If a foreign lender is engaged in a US trade or business, the question is how much of that lender's income is “effectively connected” with the US trade or business. • Interest and other investment income is effectively connected only if it has a sufficient connection with the US trade or business. • The rules are divided into two sets: (i) one for taxpayers that are engaged in a “banking, financing, or similar business,” and (ii) another for taxpayers that are so engaged. • These rules are “all or nothing” – either all of the interest from a loan will be ECI or none of it will.
42. Taxation of Interest in Treaties • US Model Treaty – the rate of withholding under Article 11 should be zero. • OECD Model Treaty – permits up to 10% of withholding for interest and it is very rare for interest income to be taxable at more than 10% by the source country. • U.N. Model Treaty – suggests higher rates for passive income in general, and for interest in particular, but leaves more tax revenues in the source country.
43. Cross Border Dividends • Source of dividends is the payor’s residence. • Sourced like interest. This is helpful because sometimes it is difficult to distinguish dividends from interests (even though they are taxed differently – interest is deductible and dividends are not). • Address Rule: the address of the recipient determines whether the payor is obligated to withhold tax on dividend payments. • There is no portfolio dividend exemption. This is a significant disadvantage for investing in stock versus debt.
44. Cross Border Dividends (cont’d) • An obvious way to avoid the withholding tax on dividends is to convert dividends into interest. • There are various financial instruments that pay interest and that will qualify for the PIE but provide a return similar to the return on stock (e.g., convertible debt). • Derivatives can also convert dividends into interest, and vice versa (discussed later).
45. Treaty Rates for Dividends • The 30% rate on interest and dividends is often reduced in tax treaties. • US Model: 0% on interest, 5% or 15% on dividends, depending on direct investment or portfolio investments. • As opposed to interest, the US model does not contain a 0% rate on dividends. – Rationale: income will be taxed in the country of residence; dividends may not.
46. Taxation of Cross Border Derivatives
47. Options, Forwards and Futures • Gain on the disposition of an option, forward, or futures contract generally is sourced according to the residence of the recipient of the gain. Section 865(a)(2). • Thus, capital gain recognized by a non-US holder generally is foreign-source gain not subject to US tax, unless the foreign holder is engaged in a US trade or business and the gain is ECI. • Section 865(j)(2) authorizes Treasury to promulgate regulations governing the source of gain from dispositions of forward contracts, futures, options, and other financial products. No regulations have been issued to date.
48. Notional Principal Contracts (“NPCs”) • Periodic and nonperiodic payments (to the extent not recast as interest under Reg. 1.446- 3T(g)) under an NPC are sourced by reference to the residence of the recipient. Reg. 1.863- 7(b)(1). • Thus, periodic and nonperiodic (to the extent not recast as interest, as explained above) payments received by a non-US holder are foreign-source income not subject to US withholding tax, assuming the non-US holder is not engaged in a US trade or business.
49. Notional Principal Contracts (cont’d) • When a non-US person that is a party to an NPC is engaged in a US trade or business and has entered into the contract in connection with such trade or business, income from the NPC may be treated as US-source income. Reg. 1.863-7(b)(3). • Periodic and nonperiodic payments constitute US-source income if the US activities of the foreign party were a “material” (although not necessarily principal) factor in realizing the income. • Payments other than periodic payments (e.g., non- periodic and termination payments) are subject to the general source rules.
50. Notional Principal Contracts (cont’d) • The source rules pertaining to NPCs were first established by the IRS in 1987. See Rev. Rul. 87-5. • Although not stated formally by the IRS, it appears that the reason behind the special rule was to permit cross-border NPCs without the impediment of a withholding tax. • Nevertheless, the IRS and several commentators have raised the concern that with respect to equity swaps, the source rules could be used to replicate payments subject to US withholding, such as dividends from a US corporation, and convert such payments into exempt swap payments. See Preamble to Reg. 1.446-3.
51. Section 871(m)
52. HIRE Act of 2010 • In 2010, Congress enacted Section 871(m), which treats certain dividend related payments made on notional principal contracts as US-source income and subject to withholding when paid to a non- US person. • Section 871(m) defines a “Specified NPC” to include any NPC if: (1) the long party to the contract transfers the underlying security to the short party (“Cross-in”); (2) the short party to the contract transfers the underlying security to the long party (“Cross-out”); (3) the underlying security is not readily tradable on an established securities market; (4) the underlying security is posted as collateral by the short party to the contract with the long party; or (5) such contract is identified by the IRS as a Specified NPC. • Payments made after March 18, 2012 on any Specified NPC that are described in clauses (1) through (4) of section 871(m) (above) have been subject to section 871(m) since that date and none of the regulations issued thereafter has changed this rule.
53. History of § 871(m) • Landscape before §871(m) • Non-US persons generally are subject to 30% withholding tax on US source dividends unless reduced or eliminated by an applicable tax treaty. • Payments under most equity derivatives are not subject to withholding, even if contingent on, or determined by reference to, a US source dividend. – Exception: certain substitute dividend payments on stock loans and repos over US equities. • Abusive transactions giving rise to §871(m) – Foreign person executes total return swap over a US equity and simultaneously transfers the underlying equity to the counterparty shortly before stock’s ex-dividend date (cross-in). After receipt of the dividend equivalent payment without reduction for US withholding tax, swap is unwound and stock reacquired by the foreign person from the counterparty (cross-out).
54. § 871(m) Timeline 2010 January 1991 Reg. section 1.863-7 (residence-based sourcing rule) March 2010 Section 871(m) enacted May 2010 Notice 2010-46 (Qualified Securities Lender Notice) November 1997 Notice 97-66 (guidance on certain substitute interest payments) September 2008 Senate Perm. Sub. Comm. on Invest. (Dividend Tax Abuse) January 2010 Industry Director Directive (guidance to revenue agents on use of TRS to avoid tax on dividends) January 2012 First set of Proposed regulations December 2013 Second set of Proposed regulations January 2017 Effective date for final and temporary regulations; IRS issues clarifying final and temporary regulations March 2014 Notice 2014-14 (limiting ELIs to those issued 90 or more days after final regulations) September 2015 Final and temporary regulations (applicable to (i) NPCs/ELIs issued on or after 1/1/2017 and (ii) NPCs/ELIs significantly modified/ fundamentally changed on or after 1/1/2017) December 2015 Final regulation effective date extended to January 1, 2017 (i.e., eliminating the “long dated contract” rule) July 2016 Notice 2016-42 (guidance on QDDs and the proposed QI Agreement) 2011 2012 2013 2014 2015 2016 December 2016 Notice 2016-76 provides staggered effective date relief, among other things
55. History of § 871(m) (cont’d) • Transactions Covered by Statutory Language of §871(m) – The following are treated as a dividend from sources within the US: • A payment on a notional principal contract that is contingent on or determined by reference to a payment of US dividend if: 1. long party transfers underlying US stock to counterparty in connection with entering into transaction (i.e., underlying US stock “crossed in”); 2. short party transfers underlying US stock to counterparty at termination of transaction (i.e., the underlying US stock “crossed out”); 3. underlying US stock not readily tradable on established securities market; OR 4. underlying US stock posted as collateral by short part to long party in connection with the transaction • Any substitute dividend paid to a non-US person under a securities loan or sale- repurchase transaction that is contingent on or determined by reference to a payment of US dividend; • Regulatory Authority under §871(m) • Section 871(m) authorizes IRS to identify payments made under other instruments that should be subject to §871(m) withholding. • Effective Date – Withholding generally applicable to any of the above listed payments made on or after September 14, 2010.
56. Section 871(m) Regulations -- Transactions Covered by the September 2015 Regulations, as Clarified in January 2017 • Dividends from sources within the US will include any payment that references the payment of a dividend from an underlying US security pursuant to: – A securities lending or sale-repurchase agreement, – A specified notional principal contract or a specified “equity linked instrument” (e.g., futures, forwards, options, convertible debt), or – Any other substantially similar payment if such instrument satisfies either the ‘delta test’ (for simple contracts) or the ‘substantial equivalence test’ (for complex contracts). • The delta and substantial equivalence tests generally are conducted at earlier of the pricing date or the date, or when instrument is significantly modified (in the case of debt) or fundamentally changed (in the case of non-debt derivatives) – Issuance date is used if pricing date is more than 14 calendar days before issuance – Special rule for options listed on a “regulated exchange” • Effective date for specified NPCs and ELIs: • For instruments executed (or materially altered) on or after 1/1/2017, applies to all payments on specified NPCs and ELIs with delta of 1 • For instruments executed (or materially altered) on or after 1/1/2018, applies to all payments on specified NPCs and ELIs with delta greater than 0.8
57. Recent Developments • In December 2019, the IRS issued final regulations (TD 9887) under section 871(m) with guidance for entities that hold certain US equities and financial products referencing US-source dividends. • In Notice 2020-2, issued concurrently with the 2019 final regulations, the IRS announced that it is extending the transition relief provided in Notice 2018-72 for two additional years and that it plans to amend the section 871(m) regulations to reflect the delayed effective/applicability dates.
58. The 2019 Final Regulations • The final regulations adopt the 2017 proposed regulations without substantive change and withdraw the corresponding 2017 temporary regulations. • The final regulations define broker for purposes of section 871(m) as a broker within the meaning of section 6045(c), “except that the term does not include any corporation that is a broker solely because it regularly redeems its own shares.” • The final regulations include rules on whether a foreign exchange is a regulated exchange such that, under the section 871(m) regulations, the delta of an option that is listed on the foreign regulated exchange may be calculated based on the delta of that option at the close of business on the business day before the date of issuance.
59. The Final Regulations (cont’d) • To constitute a regulated exchange under the section 871(m) regulations, the final regulations specify that the foreign exchange must (1) be regulated by a government agency in the jurisdiction in which the market is located, (2) maintain certain requirements designed to protect investors and to prevent fraud and manipulation, (3) maintain rules to promote active trading of listed options, and (4) have had trades for which the average trading volume exceeded US$10 billion per day during the prior calendar year (the $10 billion threshold).
60. The Final Regulations (cont’d) • The IRS declined to adopt the sole comment received on the 2017 proposed regulations, which had requested the elimination of the $10 billion threshold. • The IRS explained that the threshold was intended to ensure that there is sufficient trading on the exchange to prevent price manipulation. • Finally, consistent with the 2017 proposed regulations, the 2019 final regulations include rules identifying which party to a potential section 871(m) transaction is responsible for determining whether a transaction is a section 871(m) transaction when multiple brokers or dealers are involved in the transaction.
61. Notice 2020-2 • Notice 2020-2 extends the transition relief included in Notice 2018-72 for two years, including extending the phase-in application of the section 871(m) regulations for delta-one and non-delta-one transactions. • Thus, the IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the section 871(m) regulations when enforcing those regulations for (1) any delta-one transaction in 2017 through 2022, and (2) any non-delta-one transaction (such as, in most cases, an option) that will come within section 871(m)’s scope in 2023. Perhaps most importantly, the rules requiring withholding generally will not apply to any payment made for any non-delta-one transaction issued before 1 January 2023.
62. Notice 2020-2 (cont’d) • Extending through 2022 the simplified standard included in Notice 2016-76 (and previously extended in Notices 2017-42 and 2018-72) for withholding agents to determine whether transactions are combined transactions. • Extending the phase-in relief for qualified derivatives dealers (“QDDs”) such that a QDD will not be subject to tax on dividends and dividend equivalents received in 2021 and 2022 in its equity derivatives dealer capacity or to withholding on those dividends. • Extending the transition rules for securities loans and the credit forward system included from Notice 2010-46 for payments made in 2021 and 2022. • The IRS plans to amend the section 871(m) regulations to incorporate the delayed effective/applicability dates. Until those regulations are issued, taxpayers may rely on the provisions of Notice 2020-2.
63. Section 385 Regulations
64. Background • Treatment of an instrument as debt or equity for U.S. tax purposes can have a significant tax impact, e.g., deducibility treaty withholding tax rate, ability to form a U.S. consolidated group. • Changes in any of these items could have detrimental consequences, e.g., cash tax impact, financial statement impact (e.g., loss of tax attributes), increased financing costs. • Issuer and holder must be members of the same expanded group (“EG”). • Applies only to U.S.-issued debt. • Two sets of rules, the Documentation Rules (later withdrawn by the IRS) and the Recast Rules. • Satisfying these rules does not guarantee treatment as debt; traditional debt-equity analysis still required.
65. The Documentation Rules • Provide documentation of four factors the Treasury Department believe are fundamental to the classification of an instrument as indebtedness. • Failure to comply with the Documentation Rules results in the instrument being automatically treated as stock, subject to certain limited exceptions. • Indebtedness issued before January 1, 2018 is exempt. • Only apply if (i) stock of an EG member is publicly traded, (ii) the EG’s total assets exceed $100M, or (iii) the EG’s annual total revenue exceeds $50M. • The documentation proposed rules have been withdrawn by the IRS.
66. The Recast Rules • Prevent characterization of an instrument as debt where the debt instrument does not effectively provide new capital to the issuer. • Although the Recast Rules technically apply for taxable years ending after January 19, 2017, debt instruments issued after April 4, 2016 are subject to the rules. • Recast Rules do not apply unless the aggregate amount of debt instruments that would be re-characterized under these rules exceeds $50M. • Credit for certain capital contributions and post-effective date E&P.
67. General Rule • A debt instrument is treated as stock if it is issued in: – A distribution, – In exchange for stock of another EG member, subject to certain exceptions, or – In exchange for assets in certain reorganization transactions.
68. Funding Rule • A debt instrument is treated as stock if treated as funding a “Funded Transaction,” which includes: – A distribution, subject to certain exceptions, – An acquisition of stock of another EG member in exchange for property, subject to certain exceptions, or – An acquisition of assets in exchange for property in certain reorganization transactions.
69. Funding rule (cont’d) • If the debt instrument is issued during the 72-month period beginning 36 months before a Funded Transaction, the debt instrument is per se treated as funding such Funded Transaction. • The Funding Rule does not apply to certain short- term/ordinary course debt instruments. • If the Per Se Rule does not apply, the Funding Rule can apply if the debt instrument is issued with a principal purpose of funding the Funded Transaction.