United States: MoFo Tax Talk - Volume 8, No. 1 May 2015

EDITOR'S NOTE

Has anyone noticed how we're in a seemingly endless discussion about tax reform? Ever since Representative Dave Camp (R. Mich.) issued his own tax reform "discussion" papers two years ago, U.S. tax reform has been an on and off "hot" tax topic. Currently, Sen. Orrin Hatch (R. Utah), chairman of the Senate Finance Committee, has convened five tax reform working groups; initial comments were due, appropriately enough, on April 15th (no extensions permitted). Of course, Tax Talk doesn't have to be a Washington insider to observe that the chief beneficiaries of all this tax reform talk are D.C. lobbyists, not without reason. As they say in Washington, if you're not at the table, you're on the menu. Anyway, hope springs eternal, even with a gridlocked Congress. This edition of Tax Talk doesn't bother with the nuts and bolts of income tax reform; instead, we focus on renewed interest in a U.S. value-added tax ("VAT"), at least among Washingtonian think tanks. The idea is that a VAT coupled with the existing income tax could permit significant tax reductions at the lower end of the tax tables (the folks that would be hurt by a regressive VAT) plus corporate tax reform. Of course, in the United States, every time a VAT is mentioned, so too is the name of former Ways & Means Committee Chairman Al Ullman (D. Ore.), who championed a VAT only to lose his House seat in the next election.

Juxtaposed against large-scale tax reform, Congress has returned to old budget tricks to pay for some obscure programs. Tax Talk reports on Senate Finance and House Ways & Means committee action approving bills paid for with artificial increases in the corporate estimated tax requirements right at the end of the budget horizon. These are offset by reductions beyond the budget horizon. We last reported on this in March 20101 and had hoped the practice had died. Apparently not.

Closer to home (i.e., technical tax stuff), Tax Talk 8.1 reports on a new phenomenon: negative interest. In Europe, some borrowers are being paid interest because their adjustable rate loan indices have dropped below zero. This is obviously the twilight zone of financial instruments tax, but we try to guide you through the tax results when an issuer issues a negative interest bond. Tax Talk also discusses an IRS ruling that exchangeable debentures constituted a straddle transaction, a Fifth Circuit decision on the tax consequences of abandoning stock held as a capital asset, and the resumption of publicly traded partnership private letter rulings. Enjoy!

IRS RULES DEBENTURES ARE PART OF STRADDLE; INTEREST NON-DEDUCTIBLE

In a recent field attorney advice, the IRS held that a taxpayer's issuance of debentures that were exchangeable for a basket of reference shares owned by the taxpayer and traded on an SEC-regulated exchange created a "straddle" within the meaning of Section 1092(c)(1). As a result, according to the IRS the taxpayer could not deduct interest payments attributable to the debentures because the interest payments are allocable to "personal property which is part of a straddle" within the meaning of Section 263(g)(1).

According to the facts of FAA 20151201F, the taxpayer issued exchangeable debentures with quarterly coupon payments at a fixed annual rate. At maturity, subject to the holder's exchange right, the holder would receive a cash payment equal to the adjusted principal amount of the debenture plus accrued and unpaid interest and other distributions. The holder could exchange the debenture at any time for either a fixed amount of reference shares or their cash equivalent amount. The taxpayer, in turn, could determine whether the holder would receive reference shares or their cash equivalent amount. The taxpayer could redeem the debenture for either an amount of cash equal to the adjusted principal amount of the debenture or the value of the reference shares.

The IRS held that the taxpayer created a straddle by issuing the debentures and holding the reference shares. Section 1092(c)(1) provides that a "straddle" means "offsetting positions with respect to personal property." Section 1092(c)(3) provides that two or more positions are presumed to be offsetting if "the positions are in the same personal property." Section 1092(d)(3)(A)(i) provides that the term "personal property" includes stock that "is actively traded and at least 1 of the positions offsetting such stock is a position with respect to such stock." The IRS held that due to the exchange feature, as the value of the reference shares increases, the debentures increase in value to the holders, and conversely become more costly to the taxpayer. Therefore, the reference shares and the debentures are presumed to be offsetting.

In addition, the IRS held that the taxpayer could not deduct interest payments attributable to the debentures because such interest payments are allocable to "personal property which is part of a straddle" within the meaning of Section 263(g)(1). Under Section 263(g)(1), "interest and carrying charges properly allocable to personal property which is part of a straddle" may not be deducted and must instead be capitalized. Section 263(g)(2) defines "interest and carry charges" to include "interest on indebtedness incurred or continued to purchase or carry the personal property." The IRS held that because the economics of the debentures reveal close relationships between the debentures and the corresponding reference shares, the interest payments attributable to such debenture qualified as "interest on indebtedness incurred to continue to purchase or carry the personal property."

STOCK ABANDONMENT PRODUCES ORDINARY LOSS

A recent tax case out of the Fifth Circuit upheld a taxpayer's strategy to make the best of a bad investment. According to the facts of Pilgrim's Pride v. Commissioner, the taxpayer purchased preferred stock from two corporations (the "Issuers") for a total of $98.6 million in 1999. By 2004, the stock had declined significantly in value and the Issuers offered to buy back the stock for $20 million. The taxpayer determined that the best course of action was to abandon the stock for no consideration because a $98.6 million ordinary abandonment loss would generate tax savings more valuable than the $20 million offered by the Issuers. Accordingly, the taxpayer surrendered the stock to the Issuers, terminating its ownership rights with respect to the Issuers. The taxpayer then claimed an ordinary loss of $98.6 million. The IRS disagreed with the character of the loss, arguing that the abandonment should be treated as a "sale or exchange," resulting in a capital loss (subject to limitation), rather than an ordinary loss.

The U.S. Treasury regulations generally allow a deduction for losses sustained in the taxable year, including losses from the abandonment of property. However, an abandonment loss is not allowed with respect to losses sustained upon the sale or exchange of property. The Internal Revenue Code includes a provision that deems certain transactions to be "sales or exchanges" for tax purposes. At issue in Pilgrim's Pride was whether this provision applied to the abandonment of stock that is held as a capital asset.

In 2013, the U.S. Tax Court agreed with the IRS, rejecting the taxpayer's argument that this provision only applied to derivative or contractual rights and did not apply to property rights inherent in ownership.2 However, the Fifth Circuit reversed the Tax Court's ruling, finding that this provision "applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets) [but] does not apply to the termination of ownership of the capital asset itself." The IRS attempted to argue that when a capital asset is abandoned, this provision applied because the inherent rights with respect to the abandoned asset were also being abandoned. The court disagreed, noting that "Congress does not legislate in logic puzzles."

The Fifth Circuit's decision may cause taxpayers to consider whether abandoning an asset and reaping a tax benefit is more beneficial than recouping a partial recovery and whether there are limits on such a strategy.

To read this Newsletter in full, please click here.

Footnotes

1 http://media.mofo.com/files/Uploads/Images/100402TaxTalk.pdf.

2 For a discussion of the Tax Court's 2013 ruling in Pilgrim's Pride, see Tax Talk Vol. 6, No. 4,available at http://media.mofo.com/files/Uploads/Images/140124-MoFo-Tax-Talk.pdf.

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.

© Morrison & Foerster LLP. All rights reserved

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