Thurs 345-515-cap marketssession2

Bank Tax InstituteCapital Markets: Recent Tax Developments (Session 2)

Larry Salva – CitigroupDavid Shapiro – PwCFrank Strong – Deloitte

November 6, 2014

Agenda

Basket Barrier Option Trade• Discussion of (i) transaction, (ii) Senate Hearing and (iii) 2 CCAs re: “change of

accounting method” issues associated with transaction

CCA 201423019 re: status as a section 475 dealer Negative repo rates Swaps after Dodd-Frank (tax issues) 871(m) developments (including conversion rate adjustments on

convertible bonds) Miscellaneous: Bitcoin & update on Camp financial product proposal

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Basket Barrier Option (Intro)

Senate subcommittee questioned a hedge fund and investment banks about certain barrier options on July 22, 2014.

In 2010, IRS had issued GLAM 2010-005 addressing similar facts. IRS has recently issued pronouncements as to whether changes to

taxpayer positions in this area constitute a change in method of accounting.

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Basket Barrier Option: Sample Terms

A hedge fund enters into a cash-settled derivative contract with a bank labelled as a “call option on a basket of securities.”

The fund pays a premium equal to 10% of the value of the securities. The bank provides the other 90% of the funds to acquire the

securities. The securities are held in a managed account in the name of the

bank. The general partner (GP) of the fund manages the account pursuant

to an investment management agreement with the bank.

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Basket Barrier Option: Sample Terms (con’t)

If the fund exercises the contract, it will be entitled to an amount of cash (“cash settlement amount”) based on the value of the securities in the managed account less the “strike price.”• The value of the managed account is based upon appreciation and

depreciation in the securities, as well as distributions, if any, on the securities, adjusted for expenses and financing costs.

• The strike price is effectively equal to 90% of the securities’ initial value. The contract has a “knock-out” or “barrier” feature, which results in

the automatic termination of the contract if the value of the securities falls below a threshold (generally, approximately 92% of the securities’ initial value) during the term of the contract.

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Basket Barrier Option: GLAM 2010-005

The contract does not function like an option, and should not be treated as such. • The interplay between the premium, cash settlement amount and knock-

out feature imposes upon the fund costs similar to an obligated buyer and precludes any possibility of lapse.

• The fund’s ability to alter the reference securities, through GP, while the contract remains open is inconsistent with the notion that an option on property must reference specific property at a defined price.

The fund is the tax owner of the securities.• The fund has full opportunity for gain and income from the performance of

the reference securities.• The fund has substantially all of the risk of loss of the reference securities.• The fund, through GP, has complete dominion and control over the

reference securities.7

Basket Barrier Option: CCA 201426025 (June 2014)

Issue: Whether the change in the characterization of the barrier option from “option” to “non-option” (i.e., from derivative to beneficial ownership of the securities by the hedge fund) constitutes a change in accounting method? • The field agent proposes current recognition of the relevant gains, losses,

income, and deductions resulting from securities trading, disallowing the effective deferral of these amounts occurring under the fund’s existing practice.

• The fund asserts that the adjustment proposed by the field agent creates a permanent difference in lifetime taxable income, and thus flunks the lifetime income test because the adjustment: involves the issue of “whether” amounts are taxable, rather than “when” amounts

are taxable, and is analogous to changes between treating an item as taxable or nontaxable, which are not accounting method changes; and

effectively converts one form of taxable income (gain or loss on option transactions) into several different types of taxable income (gain or loss on securities transactions, interest expense, fees, etc.)

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Basket Barrier Option: CCA 201426025 (con’t)

Conclusion: The change in the characterization constitutes a change in accounting method. • The adjustment merely impacts the time when taxable income would be

recognized.• The fund’s argument elevates form over substance and places undue

significance on the labelling of types of taxation income. The amount the taxpayer recognizes as option gain (or loss) effectively includes

the gains, losses, income, and deductions proposed by the field agent albeit under a different label.

The adjustment proposed by the field agent does not merely consist of recognizing gains, loss, income, and deductions on basket transactions consistent with beneficial ownership of the basket securities; the adjustment also includes a corresponding removal of gains recognized by the fund when the contract ends.

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Basket Barrier Option & 475: CCA 201432016 (August 2014)

Background • The taxpayer made a Section 475(f) election as a trader in securities but

did not account for any of its basket transactions under Section 475 mark-to-market (MTM) method of accounting.

• The taxpayer claims that it originally thought that it could make separate Section 475(f) elections for each line of trade or business it owned, and thus, did not make a Section 475(f) election for the basket transactions.

• The taxpayer argues that if it cannot make separate elections, then there is no change in method of accounting, but rather a correction of an error.

• The IRS, in making the following conclusions below, held that the election under Section 475(f) is made on an entity-by-entity basis, not a separate trade or business basis. Only in the case of separate commodities and securities businesses can a taxpayer make separate elections.

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Basket Barrier Option & 475:CCA 201432016 (con’t)

Conclusions: • Application of Section 475 if the basket transactions are recharacterized as

non-options The underlying positions are considered securities and are subject to MTM

method of accounting unless certain exceptions (i.e., not held in connection with its trading business) apply.

The treatment of the underlying basket of securities as securities subject to MTM method of accounting is a change in method of accounting.

• Application of Section 475 if the IRS fails in challenging the taxpayer’s treatment of the basket transactions as options Even if the basket transactions were properly treated as options, they do not

appear to be Section 1256 contracts. Because they are not Section 1256 contracts, they are securities subject to MTM method of accounting.

The taxpayer’s failure to mark the options when they were subject to Section 475 is a material item and a timing practice that was consistently done. Any adjustment that conforms the practice to the MTM method would be an accounting method change, rather than a correction of an error.

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Status as section 475 Dealer: CCA 201423019

Background: • The taxpayer was a holding company of a partnership that was engaged in

the business of originating and purchasing mortgage loans on the open market. The partnership also participated in mortgage-backed securitization activities.

• Year 1, the partnership contributed the mortgage loans to the DE Trusts and the trusts issued notes to third party investors as mortgage-backed securities. The trust also issued residual interests to the partnership.

• Year 2, the partnership sold the residual interests to the taxpayer.• There were three servicing agreements in place; one each for the Master

Servicer, the Servicer and the Subservicer. The respective agreements identified each servicer as independent contractor.

• The servicing of the underperforming loans was assigned to the Subservicer. Under the agreement, the Subservicer could not modify the terms of the loans unless the default was imminent and only to avoid default. The loan modifications generally involved deferred interest payments, lowered interest rates and reduced penalties.

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Status as section 475 Dealer: CCA 201423019 (con’t)

Background (con’t): • Year 3, the Subservicer, an LLC that was a wholly owned disregarded

subsidiary of the partnership, engaged in significant and ongoing loan workout activities on certain mortgage loans.

• The taxpayer claimed that these modified loans were significantly modified, creating taxable exchanges under Treas. Reg. § 1.1001-3. The Taxpayer recognized gain on the modifications.

• The taxpayer argued that the significant loan modifications resulted in new loans which constituted dealer activity under section 475. The taxpayer asserted that the dealer activity should be attributable to the taxpayer being the owner of the residual interests in the DE Trusts.

• The taxpayer’s ultimate position is that it was entitled to MTM all the significantly modified mortgage loans and claimed loss.

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There were three issues raised. This discussion will focus on two issues:• Whether the taxpayer is a securities dealer because of its interest in the

partnership? • Whether the Subservicer’s loan modification activities constitute a dealer

activity under section 475 and are attributable to the taxpayer?

Issue #1: The taxpayer is not a securities dealer because of its interest in the partnership that was a such a dealer.• The partnership, though a flow-through entity, is a separate entity from the

taxpayer. Although the ordinary character of the marked securities flowed through to the taxpayer, the dealer activities of the partnership are not attributable to and do not flow through to the taxpayer.

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Issue # 2: Subservicer’s loan modification activities do not otherwise cause the taxpayer to be treated as a securities dealer.

a) The Subservicer’s activities are not attributable to the taxpayer.i. Although it is a disregarded entity, it is a disregarded entity of the

partnership, which is a separate entity from the taxpayer. Its activities may be attributable to the partnership but they are not attributable to the taxpayer.

ii. There is no agency relationship. The servicing agreement provides that the Subservicer is an independent contractor.

b) The loan modification activities do not meet dealer requirements. i. Although the loan modifications may have been a debt-for-debt exchange

for section 1001 purposes, they are not considered as originating new loans for section 475 purposes. The loan modifications were for a limited purpose, which is to preserve the collateral.

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Issue # 2(b)ii. The customer requirement was not met. The debtors remained the

customers of the partnership. The purpose of the modification was not to generate profit from a mark-up in price, as would be expected from a dealer when dealing with its customers. The modification resulted in lowered interest rates, reduced penalties and deferred interest payments. These activities do not constitute making loans to customers.

iii. The Subservicer was in the business of servicing loans and not in the business of being a mortgage loan originator. The fact that it may occasionally do some loan modifications does not make it a loan originator.

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Classic Repo: Stage 1 (Initiation of the trade)

Lender(Security Buyer/ Re‐Seller)

Borrower(Security Seller/Re‐purchaser)

“Sale” of Security (FMV $100)

$100

+ Obligation to resell for $100 plus interest charge+ Obligation to pay substitute interest/dividends while trade is open

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+ Obligation to re‐purchase for $100(‐) plus interest charge

Classic Repo: Stage 2 (Settlement/closing of trade)



“Re‐purchase” price of $100 plus interest charge

“Re‐sale” of Security

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But what if Lender (Security Re‐seller) is unable to delivery the security when the Borrower is prepared to re‐purchase?• Prior to the introduction of a “fails charge,” the penalty on Lender was simply that Borrower no

longer had to pay interest on the balance due – i.e., Borrower retained the cash, and would not pay interest on it (re‐purchase price remained unchanged).

• Thus, when interest rates were low, the economic penalty to Lender was also small.• In times of market stress, it could be difficult (or expensive) for the Lender to acquire the security to

return to the Borrower. (Holders of the security can be reluctant to make them available.) In these circumstances, Lenders often failed to deliver securities – opting to incur the small economic cost of forgone interest, rather than the larger cost required to get holders to part with their securities.

Assume total of $101 (for simplicity)

Fails Charge on Classic Repo:

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Some markets now impose a “fails charge” when the lender does not deliver security pursuant to a repo – e.g., Lender now must pay 3% per annum on balance of the purchase price (accrued daily while the security has not been delivered).

Regulations now indicate that certain of these “fails charges” are sourced by reference to the residence of the recipient. (No withholding when paid to foreign person.)

See TR 1.863‐10 – “qualified fails charges” (must relate to Treasuries)

Sometimes, the security underlying the repo can be so “special” (e.g., hard to borrow, hard to find, etc.) that the Lender can anticipate that it may be difficult/expensive to return the security at maturity of the repo. Rather than risk paying the 3% “fails charge,” the Lender prefers to negotiate a cheaper exit strategy upfront, by reducing its repurchase price – i.e., rather than pay a large fails charge later, the Lender negotiates its receipt of a lower amount in the future.

(Perhaps another way of saying this – the Lender needs the security on day 1 for some other purpose (because it is so “special” that it is willing to forgo interest.)

Leads to the Negative Rate Repo:



“Re‐purchase” price of $98

“Re‐sale” of Security

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Stage 2 (Settlement/closing of trade)



“Sale” of Security (FMV $100)

$100+ Obligation to resell for $98+ Obligation to pay substitute interest/dividends while trade is open

+ Obligation to re‐purchase for $98

Stage 1 (Initiation of trade)

Lender pays negative interest? Borrower has $2 of income – what source? Withholding obligations?

Swaps After Dodd-Frank

Dodd-Frank Reform

• Provides for government regulation and supervision of the derivative financial instruments to minimize risk to the financial system

• Calls for the clearing of many swaps through regulated central clearinghouses and the trading of those swaps on regulated markets such as an exchange

• Because clearinghouses require standardized contracts rather than contracts written based on current market conditions, counterparties must make upfront payments based on the present value of the difference between the standard coupon rate and current market rate

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Tax Treatment of the Upfront Payment

• Treas. Reg. § 1.446-3(g)(4) provides that when a notional principal contract (NPC) includes a significant nonperiodic payment, the contract is generally treated as two separate transactions: an on-market, level payment swap and a loan.

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Tax Issues Resulting from Deemed Loan Treatment (raised in SIFMA et al. letter cited below)

• The deemed loan by controlled foreign corporation (CFC) to the U.S. person (parent) may be considered a U.S. property for purposes of section 956, giving rise to deemed dividend inclusions by the U.S. person. Treas. Reg. § 1.446-3(g)(4) further provides that for purposes of section 956, the

IRS may treat any nonperiodic payment in connection with a swap, whether or not it is significant, as one or more loans.

• The interest on the deemed loan may be subject to withholding and information reporting. It is not clear whether the exemption from withholding and information reporting

concerning payments under an NPC to a foreign payee applies to deemed interest payments resulting from the treatment of a significant upfront payment as a loan. Treas. Regs. §§ 1.1441-4(a)(3)(i) and 1.1461-1T(b)(1).

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Swaps under Dodd-Frank

Tax Issues Resulting from Deemed Loan Treatment (cont’d)

• Implementation of section 1471-1474 (FATCA withholding) may apply both to interest payments under a deemed loan and to the gross proceeds from the retirement or redemption of a deemed loan. Sections 1473(a)(A)(i) and (ii).

• An upfront payment under a swap received by a tax-exempt organization or a fund in which such tax-exempt organization invests may give rise to unrelated business taxable income (UBTI) under section 514.

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Swaps under Dodd-Frank

Industry Position

• CME Group, Inc., the Securities Industry and Financial Markets Association (SIFMA), the North American Tax Committee of the International Swaps and Derivatives Associations (ISDA), and the Futures Industry Association (FIA) requested the Treasury Department and the Internal Revenue Service to issue guidance providing relief from Treas. Reg. § 1.446-3(g)(4) treating as loans for federal income tax purposes swap upfront payments constituting significant nonperiodic payments.

• They claimed that the above regulations were promulgated before the advent of cleared swaps and when upfront payments and off-market swaps were highly out of the ordinary. Previously, if an upfront payment was received, the party receiving the payment was free to use the payment for its own business purposes (except to the extent that the terms of the swap required that party to provide corresponding collateral to the payor), rather than depositing it with a centralized depository. 25


Industry Position (cont’d)

• In the context of cleared (and current market practice for many uncleared) swaps, the party receiving an upfront payment is not entitled to retain the payment, but rather must remit the payment as variation margin back to the payor of the upfront payment. Such upfront payments therefore lack the debt-like attributes that were of concern when the existing regulations were issued.

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Limited Fix: Section 956 Temporary Regulations• Provide an exception to the definition of U.S. property for obligations of U.S.

persons arising from upfront payments made with respect to contracts that are properly classified as NPCs. Treas. Reg. § 1.956-2T(b)(1)(xi)

• State that the obligations of U.S. persons arising from such upfront payments by a CFC that is dealer in securities or commodities (within the meaning of section 475) do not constitute U.S. property for purposes of section 956. Treas. Reg. § 1.956-2T(b)(1)(xi)(A).

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Swaps After Dodd-Frank Limited Fix: Section 956 Temporary Regulations (cont’d)

• To qualify for this exception:1. The upfront payment must be required under a contract that is cleared by a

derivatives clearing organization (as defined in section 1a of the Commodity Exchange Act) or a clearing agency (as defined in section 3 of the Securities Exchange Act of 1934) that is registered as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act of 1934, respectively;

2. The CFC must make the upfront payment to or through a U.S. person that is a clearing member of a derivatives clearing organization or clearing agency, or directly to the derivatives clearing organization or clearing agency if the CFC is a clearing member of such derivatives clearing organization or clearing agency;

3. The upfront payment must be made directly or indirectly to the counterparty to the contract;

4. The counterparty to the contract must be required to make a payment that is in the nature of initial variation margin that is equal (before taking into account any change in the value of the contract between the time the contract is entered into and the time at which the payment is made) to the amount of the upfront payment made by the CFC; and

5. Such payment in the nature of initial variation margin must be paid, directly or indirectly, to the CFC.

Treas. Reg. §§ 1.956-2T(b)(1)(xi)(B) through (F).28


Limited Fix: Section 956 Temporary Regulations (cont’d)‒ Apply to payments made on or after May 11, 2012 but taxpayers could

apply the rules retroactively to payments made prior to May 11, 2012.

• Expire on May 8, 2015.

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PwC

The Basic Trade – Total Return Swap to avoid dividend withholding

Synthetic Exposure to underlying US equities via an swap

Amounts Equivalent to Dividends on X Stock

LIBOR +/- Spread

Appreciation

Depreciation

Dealer ForeignCorp

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PwC

Background and timelineDividend equivalents

January 1991 Section 1.863-7 – No withholding on swaps

November 1997 Notice 97-66

September 11, 2008 Senate Permanent Subcommittee on Investigations Hearing – “Dividend Tax Abuse: How Offshore Entities Dodge Taxes on US Stock Dividends”

January 2010 IDD on Dividend Withholding in TRSs

March 2010 “HIRE ACT” – enactment of “dividend equivalent” rules of 871(m)

January 2012 “Old” proposed 871(m) regulations

December 2013 “New” proposed 871(m) regulations

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PwC

Section 871(m), the statute “Dividend equivalents” subject to tax: 3 Statutory Paths

Dividend equivalent:• Substitute payment on securities loan or sale-repurchase• Payment made on “Specified notional principal contract” (SNPC) that is

contingent or determined by reference to US-source dividend• Other payments as defined in regulations, unless “contract is of a type

which does not have the potential for tax avoidance” Specified NPC: Any notional principal contract where1. Cross-in2. Cross-out3. Illiquid underlying4. Underlying posted as collateral

PwC

Section 871(m) “Old” proposed regulations – 7 sins

Specified NPC was defined by reference to “7 sins”:1. Long party “in the market” on date NPC priced/terminated2. Underlying not regularly traded3. Underlying posted as collateral4. NPC has a term of fewer than 90 days5. Long controls short party’s hedge6. NPC represents significant amount of trading volume7. NPC is over a special dividend

Observations:• Equity-linked instruments” (ELI) are subject to same rules• Difficult for withholding agents• Some swaps would be okay

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PwC

Section 871(m) “New” proposed regulations – delta of .70

Specified NPC:• Any NPC that has a delta of .70 or greater at the time the long party

acquires Specified ELI:

• Any ELI that has a delta of .70 or greater at the time of long party acquires and ELI was acquired after March 5, 2014

Operative rule:• DE is payment on SNPC or SELI in that references a dividend on

underlying equity in 2016 or later• Amount of DE is determined by delta on date of dividend

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PwC

Section 871(m) Where we are; where we are going

March 2010 status quo continued for 2014 and 2015• Swaps okay provided (1) no cross-in, (2) no cross-out, (3) not illiquid, (4)

no pledge• Equity-linked instruments, including option, forwards, convertible

instruments are okay January 2016 and forward

• Delta approach will apply• No real gap between swaps (NPCs) and ELIs• One year to comment/complain (2014)• One year to get withholding systems in place (2015)

Reporting burdens Special issues relating to convertible bonds (coordination with

section 305) • NYSBA report

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What are Bitcoins? How are they taxed? No physical form Not backed by any central government Anonymous feature Volatility

How to obtain Bitcoins Mining Third party exchanges Payment for goods and services

Notice 2014‐21 concludes that virtual currency is treated as property for U.S. federal income tax purposes and is not treated as currency. Therefore, the general tax principles applicable to property transactions should apply to virtual currency transactions. As a result, taxpayers who receive virtual currency as payment for goods or services must include the fair market value of the virtual currency received in gross income, and their basis in the virtual currency received as payment for goods and services equals the fair market value of the virtual currency on the date of receipt.

PwC

Overview of the Camp Proposals

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• Mark‐to‐Market of Derivatives (including new “mixed straddle” proposal)

• Book‐Tax Conformity for Hedging Identification

• Modification to Treatment of Debt Instruments• Issue price determination for modifications of “distressed debt”

• Current inclusion of market discount

• Deductions for amortizable bond premium

• Mandatory Use of Weighted Average Method of Cost Accounting of Securities

• Changes to Wash Sale Rules

PwC

Disclaimer

This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation.

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