United States: MoFo Tax Talk, Volume 8, No. 4 January 2016

EDITOR'S NOTE

Q4 2015 saw one of the biggest tax bills to come along in some time. By all accounts, the "Protecting Americans from Tax Hikes," or PATH Act, was a rush job. That means it will take years to find the goodies (and what paid for them). One clear winner even now: foreign investors in U.S. real estate. Congress added some new provisions to the Foreign Investment in Real Property Tax Act ("FIRPTA"), which will make investment in U.S. real estate more attractive (taxwise, at least), particularly for publicly traded foreign funds in certain jurisdictions and for foreign pension funds. Much of this change will also encourage investment in U.S real estate investment trusts ("REITs"). Tax Talk explains it all.

Speaking of Subchapter M, right after the end of the quarter, the Internal Revenue Service ("IRS") provided some welcome relief for U.S. regulated investment companies ("RICs") that have received or will receive refunds of foreign dividend withholding taxes. In 2012, the European Court of Justice held that the imposition of withholding taxes on U.S. RICs violated the EU's nondiscrimination principles. Since then, RICs have been pursuing refunds from individual EU governmental tax authorities. The problem is that Internal Revenue Code ("IRC") section 905(c) requires an amended return when a foreign tax refund is received. This is impossible for a widely held RIC because its thousands of shareholders claimed the credit many years ago and there is no mechanism to pass through a refund, let alone to find the shareholders that were there at the time. The IRS guidance (which we discuss below) isn't perfect, but will help funds work through these problems.

In other Q4 news, Tax Talk reports on the Sixth Circuit reversing the Tax Court on what can be a "foreign currency contract," the extension of the effective date of the dividend equivalent rules, a PLR on the effects of consent payments for contingent debt, the Supreme Court granting certiorari in a case deciding a REIT's "citizenship," and more. Finally, as we've done in prior election cycles, Tax Talk summarizes the tax plans of the various Republican and Democratic presidential candidates.

IRS PROVIDES RICS ALTERNATIVES TO ACCOUNT FOR FOREIGN TAX REFUNDS

Generally, when a U.S. taxpayer pays foreign tax, the U.S. taxpayer is entitled to take a credit (a "Foreign Tax Credit") against the taxpayer's U.S. tax liability. The purpose is to avoid double taxation. When a RIC pays foreign tax, it has two options: it can either claim the foreign tax credit itself to offset any tax liability, or under certain circumstances, it can make a "Section 853 Election" that allows the RIC to pass through the foreign tax credit to its shareholders. In other words, the RICs shareholders are entitled to claim the foreign tax credit directly on their tax returns. Under existing rules (the "Default Method"), a taxpayer that receives a refund of foreign taxes is required to notify the IRS, which redetermines the taxpayer's U.S. tax liability in the year in which the credit was taken. Due to a recent ruling by the EU Court of Justice, many RICs have received refunds of foreign taxes paid by the RIC in prior years. These refunds have caused RICs to question whether the existing rules regarding foreign tax credit refunds are administrable when applied to RICs that have made Section 853 Elections.

Notice 2016-10 (the "Notice"), released on January 15, 2016, by the IRS, gives RICs additional options when faced with refunds of foreign taxes paid in prior years. Generally, the Notice allows RICs to treat foreign tax credit refunds under two methods. The first method, the "Netting Method," applies to a RIC that, in the same year in which it receives a refund of foreign taxes (the "Refund Year"), also pays an amount of foreign taxes equal to or greater than the refund (including interest received from the foreign taxing jurisdiction). Essentially, the RIC is permitted to use the foreign tax refund received to offset the foreign tax paid in the Refund Year. As a result, the RIC is not required to separately include the tax refund in its gross income, and shareholders are able to take advantage of foreign taxes paid by the RIC that are not offset by the refund. The Netting Method is available to RICs if (1) the economic benefit of the refund inures to the RIC's Refund Year shareholders, (2) the RIC was not held predominantly by insurance companies or fund managers in connection with the creation or management of the RIC, (3) the RIC makes a Section 853 Election in the Refund Year, and (4) (as discussed above) foreign taxes paid by the RIC in the Refund Year equal or exceed the amount of the foreign tax refund (including interest received from the foreign taxing jurisdiction). If a RIC takes advantage of the Netting Method, the RIC is required to file an information statement with the IRS.

The second method under the Notice allows RICs that receive a refund of foreign tax to request a closing agreement with the IRS addressing the treatment of the refund, which the IRS will grant where such agreement is found to be in the interest of sound tax administration. According to the Notice, a closing agreement will generally be considered to be in the interest of sound tax administration where (1) the RIC demonstrates that it is precluded from applying either the Default Method or the Netting Method, and (2) the RIC provides information sufficient to establish a reasonable estimate of the aggregate adjustments that would be due under the Default Method.

The Notice also states that the IRS intends to promulgate regulations in the future that memorialize these rules. Until that time, RICs may rely on the Netting Method as described in the Notice to address refunds received in past tax years.

SIXTH CIRCUIT REVERSES TAX COURT: A FOREIGN CURRENCY OPTION CAN BE A "FOREIGN CURRENCY CONTRACT"

In Wright v. Commissioner,1 taxpayers, the Wrights, challenged a Tax Court decision upholding an IRS deficiency claim. The Wrights had engaged in a majorminor transaction detailed as follows: (i) the Wrights were members in an investment company called Cyber Advice, LLC, which was treated as a partnership for federal income tax purposes; (ii) Cyber Advice paid premiums to purchase reciprocal offsetting put and call options (the purchased options) on a foreign currency in which positions are traded through regulated futures contracts (the "major currency"— here, the euro); (iii) Cyber Advice received premiums for writing reciprocal offsetting put and call options (the written options) on a different foreign currency in which positions are not traded through regulated futures contracts (the "minor currency"—here, the Danish krone); (iv) the net premiums paid and received substantially offset one another and the values of the two currencies underlying the purchased and written options historically demonstrated a very high positive correlation with one another; (v) Cyber Advice assigned to a charity the purchased option that had a loss and the charity also assumed Cyber Advice's obligation under the offsetting written option that had a gain; and (vi) the Wrights, as members of Cyber Advice, took the position that the purchased option assigned to the charity is a contract subject to Section 1256 of the Code, marked the purchased option to market under Section 1256 of the Code, and claimed a loss.

This transaction is similar to the transaction in Summitt v. Commissioner,2 a case discussed in an earlier edition of Tax Talk,3 which held that foreign currency options are not foreign currency contracts within the meaning of Section 1256 of the Code; therefore, the Summitt taxpayers were not allowed to claim the losses resulting from their major-minor transaction. In following Summitt, the Tax Court also rejected the Wrights' argument that foreign currency options were foreign currency contracts within the meaning of Section 1256 because options are not contracts that "require delivery of, or the settlement of which depends on the value of, a foreign currency" as set forth in Section 1256(g)(2)(A)(i).

On appeal, the Sixth Circuit reversed and remanded. The Sixth Circuit held the Tax Court's ruling was incorrect because it ignored the plain language of the statue.

Section 1256(g)(2) defines a foreign currency contract as:

(A) Foreign currency contract.—The term "foreign currency contract" means a contract—

(i) which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts,

(ii) which is traded in the interbank market, and

(iii) which is entered into at arm's length at a price determined by reference to the price in the interbank market.

The Commissioner took the position that Section 1256(g)(2) is a unified provision that provides that a contract must mandate at maturity either a physical delivery of a foreign currency or a cash settlement based on the value of the currency; however, the Sixth Circuit disagreed with this interpretation of the statue. The Sixth Circuit explained that the use of the word "or" between the delivery and settlement phrases indicated that the phrases described two ways in which a contract may qualify as a foreign currency contract; either the contract (1) could require delivery of a foreign currency or (2) could be a contract the settlement of which depends on the value of a foreign currency. Accordingly, an option "could be" a foreign currency contract.

In reversing the Tax Court's decision, the Sixth Circuit recognized that tax policy did not appear to support allowance of the Wrights' claimed losses; however, this was not a reason sufficient to reform the statutory language. The Sixth Circuit stated that there were two alternatives more appropriate for dealing with the type of abuse observed in the transaction. First, it stated that Congress allows the secretary to prescribe regulations to exclude any type of contract from the foreign currency contract definition if the inclusion of the type of contract would be inconsistent with the purposes of Section 1256. Also, according to the Court, Congress allows the Commissioner to prevent taxpayers from claiming inappropriate tax losses by challenging specific transactions under the economic substance doctrine. Tax Talk will keep an eye on this case as it continues.

RULING ADDRESSES EFFECTS OF CONSENT PAYMENTS ON CONTINGENT DEBT

PLR 201546009 addresses the tax treatment of consent payments to holders of an outstanding issuance of contingent payment debt instruments.

Taxpayer, a publicly traded corporation, issued a series of publicly traded debentures (the "Notes") treated as contingent payment debt instruments ("CPDIs"). As CPDIs, the Notes were treated under the noncontingent bond method whereby holders of the Notes ("the "Noteholders") would accrue original issue discount at the Taxpayer's "comparable yield," the rate at which Taxpayer would otherwise borrow on a similar noncontingent debt instrument. Likewise, Taxpayer was allowed to take deductions at the comparable yield. Additionally, a "projected payment schedule" is determined for the Notes that serves as a benchmark by which Noteholders recognize income on the Notes as contingencies resolve. If Noteholders receive an amount greater than the projected payment amount, this results in a "positive adjustment" that is generally treated as additional interest. If Noteholders receive less than the projected amount, this results in a "negative adjustment" that can be used to offset prior interest inclusions, subject to limitation.

Under the ruling, Taxpayer intended to achieve a spinoff whereby assets would be contributed to a newly formed corporation ("SpinCo") in exchange for SpinCo stock, followed by a distribution of SpinCo stock to Taxpayer's shareholders in redemption of such shareholders' stock in Taxpayer. Taxpayer had recently consummated a prior spinoff; however, a dispute arose as to whether the spinoff violated Taxpayer's financial covenants under outstanding debt. Although Taxpayer won the ensuing litigation, the process was costly and time-consuming.

In order to ensure a smoother spinoff this time around, Taxpayer sought to negotiate a payment with Noteholders to make a one-time payment in exchange for their consent to the spinoff (the "Consent Payment"). The Consent Payment would not otherwise affect the terms of the Notes. At issue in the PLR is whether the Consent Payments result in a deemed exchange of the Notes under Section 1001, which would cause Noteholders to realize any gain or loss in the Notes at the time the Consent Payment was made.

The regulations under Section 1001 provide that gain or loss is recognized on an exchange of property differing materially in kind or in extent. The regulations also provide that alterations to the terms of a debt instrument may result in a deemed exchange if (1) there is a modification to the debt instrument and (2) such modification is significant.

First, the IRS found that the Consent Payment resulted in a modification of the debt instrument under the Section 1001 regulations because the Noteholders were receiving a payment that they would not otherwise be entitled to. In other words, the Consent Payment altered the legal rights of the Noteholders, which gives rise to a modification under the regulations.

Generally, whether the modification of a CPDI is significant is based on the facts and circumstances. In the case of debt instruments other than CPDIs, the regulations provide a mechanical Yield Test that examines the change in the yield on the debt instrument as a result of the modification. The PLR finds that, under the facts of the PLR, it is appropriate to apply the yield test to the Notes, despite the fact that the Notes are CPDIs. The PLR appears to be the first piece of IRS guidance that examines the application of the Section 1001 regulations to CPDIs.

The Yield Test compares the original yield of the debt instruments (which, in this case, is the comparable yield, determined under §1.1275-4(b)(4) as of the issue date of each note) with the "go-forward yield" of the debt instruments. The "go-forward yield" is the yield on a hypothetical note that (1) is issued on the date of the modification, (2) has an issue price equal to the adjusted issue price of the Notes, reduced by the amount of the Consent Payment, and (3) a projected payment schedule consisting of the remaining projected payments on the Notes. If the "go-forward yield" does not exceed the original yield by the greater of (1) 25 basis points or (2) 5% of the original yield, the modification is not significant.

The PLR does not examine whether there is a significant modification of the Notes in question — the test outlined in the PLR would be run on the date of the Consent Payment. However, the PLR further finds that if the modification is not "significant" under the Yield Test, the Consent Payment would generally be treated as a "positive adjustment" under the CPDI rules and generally treated as additional interest to Noteholders.

EXTENSION OF DIVIDEND EQUIVALENT RULES

In September 2015, the IRS issued new final and temporary Treasury regulations under Internal Revenue Code Section 871(m) that cover dividend equivalent payments to nonresident aliens.4 Generally, the rules treat "dividend equivalents" paid under certain notional principal contracts and equity-linked instruments as U.S. source dividends and therefore subject to U.S. withholding tax if paid to a non-U.S. person. The initial release of the rules had an effective date that was graduated over 2015, 2016, and 2017. Contracts entered into in 2015 were exempt from the rules, contracts issued in 2016 were only subject to the rules if the contracts made payments in 2018 or onwards, and all contracts issued in 2017 were captured. The concern among issuers of financial contracts was that the two and a half months between September and January 1, 2016 was not enough time to put in place the infrastructure to comply with the record-keeping, determination, and withholding requirements under the regulations. On December 7, 2015, the IRS issued an amendment to the new dividend equivalent regulations to change this effective date.5 Now, the dividend equivalent regulations only apply to any payment made on or after January 1, 2017, for any transaction issued on or after January 1, 2017. Thanks to the extension, issuers will have the full 2016 calendar year to develop the architecture to meet the requirements of the new regime.

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Footnotes

1 117 AFTR 2d 2016, (6th Cir. 2016).

2 134 T.C. 248 (2010).

3 For a more detailed analysis of Summit v. Commissioner, please see our previous Tax Talk article at: http://media.mofo.com/files/Uploads/Images/100716TaxTalk.pdf.

4 For a more detailed discussion of the new regulations, see our Client Alert, available at http://www.mofo.com/~/media/Files/ClientAlert/2015/09/150921DividendEquivalent.pdf.

5 The published amendment also makes some immaterial edits in other places in the rules.

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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