Editor's Note
With Q1 already in the books, this issue of Tax Talk brings you the latest tax developments and news from 2013 so far.
The biggest Q1 news in our small corner of the world is possible financial instrument tax reform in the United States. In January, Rep. Dave Camp (R-MI), Chairman of the House Committee on Ways and Means released a proposal to radically change the U.S. system for taxing financial derivatives. This proposal is one of three; the two others cover international tax and pass-through taxation. The proposal for financial instruments, which is styled as a "Discussion Draft," would adopt a mark-to-market system, in which all derivatives would be treated as sold at the end of the taxable year. The taxpayer would recognize ordinary gain or loss in the deemed sale with a corresponding basis adjustment. This mark-to-market regime would ostensibly bring much-needed uniformity (and simplicity) to the tax law governing financial instruments. However, the proposal is not without controversy, and we outline the key details in this issue of Tax Talk. Those who look for clairvoyance in this piece will be disappointed: Tax Talk will never attempt to predict whether mark-to-market will become law.
On the other side of the aisle, a pair of Democrats has introduced a bill that would impose a pithy - but nettlesome - financial transactions tax of 3 basis points on certain "covered transactions" occurring or cleared on a United States facility. Similar proposals have been introduced in Congress since the financial crisis. This type of "financial transactions tax," billed as a quick fix to the budget sequestration debacle, has been met with widespread enthusiasm throughout Europe. We have a hunch it won't be as popular on this side of the pond. Stay tuned!
As we indicated in our previous issue of Tax Talk, the final regulations implementing the Foreign Account Tax Compliance Act ("FATCA") (www.KNOWFatca.com) were issued in January. We highlight the key provisions of these complicated, and far-reaching, rules. As promised, the Treasury Department has been busy this quarter negotiating intergovernmental agreements with a number of countries to facilitate FATCA compliance. For example, on Valentine's Day, the United States and Switzerland signed a "Model II" intergovernmental agreement - the first and only Model II agreement entered into by the United States to this point. Moreover, as we go to press, the United States has just signed a "Model I" agreement with Norway; Model I agreements have also been initialed with Germany, Italy, and Spain.
Not to be outdone, the IRS has also been busy, recently releasing private letter rulings relating to the consolidated income tax return rules and the so-called bankruptcy exception to the NOL limitation rules. The first private letter ruling addressed whether a wholly-owned subsidiary could be included in its parent's affiliated group, even though the subsidiary's shares were subject to a proxy agreement entitling the proxy holders to exercise exclusive control over the subsidiary's management. The ruling has important implications for subsidiaries indirectly owned by foreign corporations that are seeking to retain valuable government contracts, but which cannot be influenced by their indirect foreign parent for purposes of maintaining security clearances.
The second private letter ruling dealt with an ownership change pursuant to a bankruptcy reorganization plan and, importantly, whether the reorganization plan would result in an ownership change that would limit the debtor corporation's ability to retain and use NOL carryforwards.
Finally, in CCA 201310027, the IRS addressed the scope of the straddle rules in connection with equity-linked debt. The IRS concluded that the equity-linked debt, which referenced shares held by the issuer, constituted part of a straddle, as defined in Section 1092. As a result, the issuer was required to capitalize the interest expense incurred on the debt under Section 263(g). As always, our regular section, MoFo in the News, concludes this issue of Tax Talk.
House Ways & Means Committee Proposal Would Require Markto- Market for Derivatives and Modify Certain Other Tax Rules
For many years, academics have proposed that the U.S. replace the current hodgepodge U.S. federal income tax rules applicable to financial derivatives with a "mark-to-market" regime. In the first significant legislative initiative ever on this topic, Representative David Camp (R. MI), Chairman of the House Committee on Ways and Means, recently released a discussion draft containing proposed legislation to reform the taxation of financial instruments. If enacted, the legislation would apply to most financial instruments beginning January 1, 2014. Designed to be part of a package of comprehensive tax reform, the proposal, if adopted, would radically alter the current taxation of financial products.
Representative Camp styled the proposal as the antidote to the next financial crisis, "The U.S. is a leader in the financial world, but our broken and antiquated tax code has failed to keep up with the rapid pace of financial innovation on Wall Street. The lack of consistent and comprehensive tax policy has contributed to some corporate scandals and the recent financial crisis that devastated our economy and threatened our standing in the global community. Updating these tax rules to reflect modern developments in financial products will make the code simpler, fairer and more transparent for taxpayers; and it will also help to minimize the potential for abuse that has occurred in the past."
The most significant aspect of the proposal would require "mark-to-market" tax treatment for derivatives. Under current U.S. federal income tax law, derivatives are taxed under a variety of regimes. Most of these regimes are based on the realization principle for gains and losses, i.e., gains and losses are taxed only when "realized" for tax purposes. Certain instruments and taxpayers (e.g., Section1 1256 contracts and dealers) are subject to mark-to-market regimes while other instruments, e.g., notional principal contracts and contingent payment debt instruments, are subject to a combination of current accrual and realization regimes.
The proposal, if adopted, would require most derivatives to be marked to market; any hedging transactions (which, under the proposal and as discussed below, will include any transaction treated as a hedging transaction for financial accounting purposes), however, will be carved out of the proposal and continued to be subject to Section 1221. The provision, if adopted, would be effective for derivatives acquired, and positions established, on or after January 1, 2014. In addition, the proposal will apply to all derivatives held by dealers, who are currently subject to Section 475 with respect to securities they hold as inventory or for sale. Under the proposal, gains and losses from derivatives would be reported on an annual basis under a mark-to-market system. Under the proposed system, all year-end unrealized gains or losses would be recognized, and the resulting gain or loss would be ordinary. The tax basis of any derivative held at the beginning of the following tax year would be adjusted to take into account gain or loss previously recognized. To the extent provided in regulations, if the fair market value of a derivative is not readily determinable, the value is determined by using the method the taxpayer has adopted for reporting purposes, or as used for obtaining credit. In addition, because the proposal would deem all items of income, gain, loss and deduction with respect to a derivative to be attributable to a trade or business for purposes of determining a net operating loss (or "NOL"), an individual taxpayer would be able to carry any NOL back for two years (and potentially receive a tax refund) and forward for 20 years. At the heart of the proposed mark-to market regime is a new - and very broad - definition of derivative. For purposes of the proposal, a derivative would be defined as: (1) any evidence of an interest in, or any derivative instrument with respect to, any (a) share of stock in a corporation, (b) partnership interest or beneficial ownership interest in a partnership interest or trust, (c) note, bond, debenture, or other evidence of indebtedness, (d) certain real property, (e) actively traded commodity, or (f) currency; (2) any notional principal contract; and, (3) any derivative instrument with respect to any interest or instrument described above. Actual stock or debt instruments, however, would not be subject to the mark-to-market regime.
A derivative would also be defined to include any option, forward contract, futures contract, short position, swap, or similar instrument. In fact, the proposal makes it clear that a derivative encompasses non publicly traded derivatives and reference, as well as swaps that do not technically meet the definition of a swap under current tax law. For example, even swaps based on information other than objective financial indices, such as temperature, precipitation, snowfall, or frost, would be subject to the proposed mark-to-market regime.
Moreover, the proposal would even apply to derivatives embedded in a debt instrument, such as convertible debt. That type of debt instrument would be bifurcated for tax purposes; the derivative component would be marked to market, the debt component would not. Contingent payment debt instruments and variable rate debt instruments, however, would not be subject to the proposed mark-to-market rules. Finally, the mark-to-market and ordinary treatment rules would apply to all positions in a straddle that includes any derivative to which the provision applies, even if these positions are not otherwise marked to market.
Notably, the discussion draft does not address the treatment of (i) any current income components of a derivative (e.g., distributions made or coupons paid with respect to a derivative prior to its maturity or settlement), or (ii) non-U.S. investors or counterparties.
The proposal also aims to simplify the identification of hedging transactions. The proposed law would treat any transaction that qualifies as a hedge for financial accounting purposes as meeting the identification requirement under Section 1221. A transaction that is treated as a hedge under U.S. GAAP, however, would only be treated as a hedge for tax purposes if it also meets the substantive requirements under current tax law.
Under current law, a borrower may recognize cancellation of indebtedness ("COD") income when a debt instrument is significantly modified, even though the borrower still owes the same actual principal amount it owed before the modification. This can happen, for example, where the fair market value of a debt instrument has declined and either there is an actual exchange of new debt for old debt or the debt instrument is modified in a way that triggers a deemed exchange under Section 1001.
In the case of certain debt modifications, however, the proposal provides that the issue price of the modified debt instrument will be the lesser of (1) the adjusted issue price of the existing debt instrument, or (2) the issue price of the modified debt instrument determined under Section 1274 if the debt instrument would be otherwise subject to that section. As a result, if the principal amount of the debt does not change, the debt modification would not result in the recognition of COD income to the borrower. In other words, COD income would not be recognized on transactions where the principal amount does not change and the modified debt has adequate stated interest. Any amount of actual principal forgiven would still result in COD income consistent with current law. This proposal would apply to the following types of debt modifications: (i) an exchange by the issuer of a new debt instrument for an existing debt instrument of the issuer, or (ii) the amendment of an existing debt instrument, including a significant modification of an existing debt instrument which is accomplished by the issuer and the holder indirectly through one or more transactions with unrelated parties. The proposal does not apply to alter the current definition of when a significant modification of a debt instrument qualifies as an exchange under current tax law. It would apply to transactions after December 31, 2013.
In a significant departure from current law, the proposal would require current inclusion in income of market discount for debt instruments purchased at a discount in the secondary market. Under current law, market discount that accrues while the taxpayer holds the debt instrument is treated as ordinary income, rather than capital gain, upon the disposition of the debt instrument, unless a taxpayer elects to include market discount in income as it accrues.
The proposal, however, would require the holder of a market discount debt instrument acquired after December 31, 2013 to currently include in gross income the market discount, amortized over the post-purchase life of the instrument. The proposal would also apply to all short-term nongovernmental bonds. The amount of taxable market discount would be limited to the amount that reflects increases in the interest rates since the debt instrument was originally issued. Specifically, the proposal would limit market discount to the greater of (a) the original yield on the debt instrument at issuance plus 5%, or (b) the applicable federal rate at the time of acquisition plus 10%. As a result, accrual of market discount would effectively be limited to accrual at prevailing market interest rates. In sum, the proposal would effectively impose parity in the tax treatment of discount vis-Ã -vis debt instruments purchased in a secondary market transaction and those purchased at original issuance.
The proposal would also authorize the deduction of amortizable bond premium as an "above-the-line" deduction which reduces adjusted gross income. For sales of certain securities on or after January 1, 2014, the proposal would no longer permit taxpayers to specifically identify which shares have been sold for purposes of determining gain or loss. Instead, taxpayers would be required to use a cost basis averaging rule similar to the method used for redemptions of mutual fund shares and other registered investment companies.
The proposal provides a grandfathering exception for securities acquired before 2014. These grandfathered securities would be treated as if they were acquired in a separate account.
Finally, the proposal would expand the current scope of the wash sale rules to disallow losses on the disposition of stock or securities if substantially identical stock or securities is acquired by a related party. For purposes of this rule, the definition of a related party includes the taxpayer's spouse, dependents, controlled or controlling entities (e.g., corporations, partnerships, trusts, or estates), and certain qualified compensation, retirement, health and education plans or accounts. The proposal punitively restricts the ability to recognize these disallowed losses by providing that the basis of the substantially identical stock or securities is not adjusted to include the disallowed loss in the case of any acquisition by a related party other than the taxpayer's spouse.
Legislative prospects for the proposal are uncertain but will likely depend in substantial part on whether and when Congress moves ahead with fundamental tax reform.
Footnotes
1 All Section references are to the Internal Revenue Code of 1986, as amended
After Months of Anticipation, Final FATCA Regulations Released
On January 17, 2013, the U.S. Department of the Treasury ("Treasury") and the Internal Revenue Service ("IRS") issued final regulations1 implementing the Foreign Account Tax Compliance Act ("FATCA").
Congress enacted FATCA in 2010 as part of the Hiring Incentives to Restore Employment Act (the "HIRE Act"), and it is housed in Sections 1471 through 1474 of the Code.2
As described in the final regulations, the purpose of FATCA is broadly to buttress the existing U.S. information reporting regime by imposing reporting requirements on certain foreign financial institutions ("FFIs"), as well as other nonfinancial foreign entities ("NFFEs") with substantial U.S. ownership.3
The mechanism laid out in the final FATCA regulations to facilitate the flow of this information is complex, and the failure to comply carries a hefty price. In short, a 30% withholding tax will be levied on any "withholdable payment" to an FFI, or NFFE, that does not agree to report certain information-spelled out in great detail in the final regulations-about their U.S. account holders or substantial U.S. owners to the IRS.
Consuming more than 500 pages, these long-awaited final regulations are comprehensive and lengthy. In fact, they are anything but light reading, and the casual reader should be cautioned about their soporific effects. They do, however, (helpfully) refine and clarify many of the information reporting and withholding tax provisions of the proposed regulations, which were issued in February 2012, and we bring you just a few of the most relevant high points.4
Perhaps the best news in the short run is the extension of the grandfathering provisions, which were set to expire under the proposed regulations on January 1, 2013. By carving out a special exception for certain grandfathered obligations from the definition of a "withholdable payment," the final FATCA regulations extend grandfathering treatment to certain obligations outstanding as of January 1, 2014. As explained in the final FATCA regulations, the extension of the grandfathering dates was motivated by the government's altruistic desire to ease potential administrative burdens and facilitate an orderly implementation of FATCA. As a result, FATCA withholding will not be required for any payment under any obligation outstanding on January 1, 2014.
To determine whether the grandfathering provisions apply in the first place, it is important to identify those obligations given special treatment under the final FATCA regulations. As a threshold matter, for purposes of the grandfathering provisions, the final regulations define an obligation to include any legally binding agreement or instrument, illustrated by the following five examples:
1. a debt instrument;
2. an agreement to extend credit for a fixed term (e.g., a line of credit or a revolving credit facility) provided that the agreement fixes the material terms at the issue date;
3. a derivatives transaction between counterparties under an ISDA Master Agreement that is evidenced by a confirmation;
4. a life insurance contract that provides that the entire contract value is payable no later than upon death of the insured; and
5. an immediate annuity contract payable for a period certain or for the life of the annuitant.
With respect to debt obligations, the final regulations determine the date the obligation is outstanding based on the issue date of the debt. Thus, whether debt issued in a qualified reopening will be treated as a grandfathered obligation depends on the original issue date of the reopened issue. The final regulations provide that a withholding agent (other than the issuer or an agent of the issuer) may, absent actual knowledge, rely on a statement by the issuer of an obligation in determining whether such obligation is grandfathered.
Consistent with the proposed regulations, in the case of an obligation treated as debt for U.S. federal income tax purposes, a material modification is any significant modification of the debt instrument.5 In all other cases, whether a modification of an obligation is material is a fact-specific inquiry. Thus, a grandfathered obligation that is materially modified after the extended grandfathering period expires would be subject to FATCA withholding, unless another, independent exception applies. In addition, the final regulations provide that a withholding agent is required to treat a modification as material only if the withholding agent knows or has reason to know that the modification is material. A withholding agent is treated as having "reason to know" for these purposes if the agent receives a disclosure of the material modification from the issuer of the obligation.
By contrast, an obligation does not include any legal agreement or instrument that is treated as equity for U.S. tax purposes, lacks a stated expiration or term,6 or constitutes a brokerage or custodial agreement.
The final regulations also address obligations that would be subject to FATCA solely because they give rise to U.S. source dividend equivalent payments under Section 871(m). These obligations are grandfathered if they are issued or executed on or before the date that is six months after the date on which obligations of that type become subject to dividend equivalent treatment.
The final regulations similarly exempt from FATCA withholding any agreement requiring a secured party to make a payment with respect to, or to repay, collateral posted to secure a grandfathered obligation.
Finally, the final regulations provide that, for purposes of "foreign passthru payments," a grandfathered obligation includes an obligation that is executed on or before the date that is six months after the date on which the term "foreign passthru payment" is defined. The final regulations have opted to punt on the definition of a foreign passthru payment for now.7 Consistent with the proposed regulations, an FFI is not required to withhold on foreign passthru payments until January 1, 2017.
Although the final FATCA regulations did not extend the withholding date for standard FDAP-type payments, such as U.S. source interest and dividends, which begins January 1, 2014, the IRS did modify the rule set forth in the proposed regulations concerning withholding of gross proceeds. The final regulations now provide that the term "withholdable payment" includes gross proceeds from any sale or other disposition of property that can produce interest or dividends that would be U.S. source FDAP income, but only if those sales and dispositions occur after December 31, 2016. This two-year extension means that gross proceeds from the disposition of property that can produce U.S. source FDAP-type income will be exempt from withholding until 2017.
The statutory definition of a "withholdable payment,"8 which was maintained in the proposed regulations, has been retained, virtually without change.9 The final regulations did, however, broaden the scope of a withholdable payment in the context of dispositions to include any contract producing dividend equivalent payments, as defined in Section 871(m) and the regulations thereunder. The final regulations clarify that these contracts will be treated as property that can produce U.S. source FDAP income, when sold or exchanged.10
Furthermore, the final regulations also clarified that withholdable payments include payments in connection with a securities lending transaction, as well as a forward, future, option or swap, or any other similar financial instrument.11
By contrast, the final regulations confirm that payments of interest or original issue discount on certain short-term obligations will not be treated as a withholdable payment; the same goes for accrued interest on the date of a sale or exchange of an interest-bearing debt obligation if the sale occurs between two interest payment dates.12 Likewise, any payment that gives rise to effectively connected income will not be treated as a withholdable payment.
Summary of Relevant Dates- See chart below
Since the proposed regulations were issued last February, Treasury has been busy trying to make good on its promise to provide an alternative to FATCA compliance for those FFIs residing in countries that have entered into information sharing agreements with the U.S.
As detailed in our previous client alerts14 and issues of Tax Talk,15 Treasury has issued two model intergovernmental agreements ("IGAs"). Technically, the IGAs do not offer a FATCA exemption, but merely offer an information sharing framework. For a complete list of FATCA partner countries to date, please see KNOWFatca.com.
The first model IGA ("Model 1 IGA"), released on July 26, 2012, requires a partner FATCA country to collect information from resident FFIs about its U.S. account holders. The required information generally will mirror the information reporting framework laid out in the final FATCA regulations. The FATCA partner country then automatically provides this information to the IRS.
The second model IGA ("Model 2 IGA"), released on November 12, 2012, operates in a similar fashion, but with one significant difference. FFIs residing in a FATCA partner country that is a party to a Model 2 IGA are still required to register with the IRS and report information about their U.S. accounts directly to the IRS.
A major benefit to FFIs covered by a Model 1 IGA-aside from the promised reduction of compliance burdens-is that they will be deemed to have satisfied FATCA's due diligence and reporting requirements. In short, these FFIs will avoid FATCA withholding altogether. FFIs covered by a Model 2 IGA, on the other hand, are still required to comply with FATCA, except as provided in their respective IGA.
GRAPH
Footnotes
1. TD 9610 (January 17, 2013). The proposed FATCA regulations were released on February 8, 2012. For pertinent information on FATCA and the proposed regulations, in general, please see our previous Client Alert, which we released on Valentine's Day last year. As you will see, our passion for FATCA has not waned, and we hope to provide you with FATCA updates in the future as further guidance is released.
2. All Section references are to the Internal Revenue Code of 1986, as amended (the "Code") and the Treasury regulations promulgated thereunder.
3. Although FATCA withholding does not replace the existing U.S. tax withholding and reporting regimes, it has added complexity and increased the administrative compliance burden. The preamble to the final regulations asserts that the IRS has attempted to streamline the final FATCA regulations to enable businesses and foreign governments to implement FATCA effectively.
4. If you are a glutton for punishment, you can digest the final FATCA regulations in their entirety by visiting our FATCA website, KNOWFATCA.com. There, you will find a complete text of the final regulations, along with a host of other important FATCA-related guidance.
5. See Treas. Reg. section 1.1001-3.
6. For example, a savings deposit or demand deposit, a deferred annuity contract, or a life insurance contract or annuity contract that permits a substitution of a new individual as the insured or as the annuitant under the contract. See Treas. Reg. section 1.1471-2(b)(2)(ii)(B)(2).
7. See Treas. Reg. section 1.1471-5(h)(2).
8. 26 U.S.C. section 1473(1) (defining "withholdable payment").
9. Treas. Reg. section 1.1473-1(a) (defining "withholdable payment").
10. Treas. Reg. section 1.1473-1(a)(3)(ii)(A), (B). In contrast, the proposed regulations appeared to have targeted only terminations of a specified notional principal contract. See Prop.Treas. Reg. section 1.1473-1(a)(3)(ii)(B).
11. Treas. Reg. section 1.1473-1(a)(4)(iii).
12. Treas. Reg. section 1.1473-1(a)(2)(vi).
13. The final regulations provide that debt obligations are considered outstanding on a date if it has an issue date before such date. Non-debt obligations are outstanding on a date if a legally binding agreement establishing the obligation was executed between the parties to the agreement before such date. Treas. Reg. 1471-2(b)(2)(iii).
15. http://www.mofo.com/files/Uploads/Images/130125-MoFo-Tax-Talk.pdf
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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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