United States: Tax Talk: Volume 9, Issue 1

Editor's Note

Things are getting crazy. No, we don't mean what's going on in the U.S. presidential campaign (although we do update you on the remaining candidates' tax positions in this issue of Tax Talk), but what's happening on the administrative law side of the tax house. In Q1, the IRS continued its ramped up rulemaking with regulations on broker reporting on debt instruments and OID on tax-exempt bonds, nonrecognition transfers of loss property to corporations, and partnership allocations of creditable foreign tax expenditures.1 Shortly after the quarter ended, surprise regulations under Section 3852 were issued as part of anti "inversion" guidance. As we reported in our Client Alert,3 these regulations have potential to affect transactions far beyond inversions, however. Counterbalancing that IRS activity is a serious upswing in talk about challenging regulations.4 While this issue has always been around, last summer's decision in Altera5 stoked the fire. Looking around at what tax advisors are speaking and writing about, some are gearing up for a massive attack on regulations. Whether clients have the same fervor, litigation budget, and willingness to challenge the government is another question.

On a quieter note, this issue of Tax Talk covers two IRS rulings on real estate investment trusts, proposed Section 305(c) regulations that contain new rules for reporting and withholding when the conversion ratio is changed on convertible debt, the IRS reconsideration of a 2016 ruling on bad boy guarantees, and more.

IRS Publishes Proposed Section 305(c) Regulations

On April 12th, the IRS published proposed regulations under Section 305(c) that address the treatment of deemed dividends to holders of stock and rights to acquire stock. If finalized as proposed, these rules would impact issuers and holders of instruments that provide for adjustments in the case of corporate distributions, including convertible bonds and warrants.

Under Section 305, a distribution of stock or stock rights by a corporation to its shareholders is generally not included in the shareholder's gross income, except in certain circumstances. For example, a distribution of stock rights to a holder of a convertible security that compensates the holder for an actual distribution to shareholders is generally considered a taxable deemed distribution and is subject to the general rules regarding taxable distributions and dividends. These types of adjustments are common for instruments that are convertible into corporate stock, such as convertible bonds.

The regulations do not propose new rules regarding whether a conversion adjustment results in a taxable exchange—the preamble to the proposed regulations states that it has been the position of the Treasury Department and the IRS for over 40 years that an increase in the conversion ratio of a convertible debt instrument is treated as a deemed distribution. Instead, the proposed regulations clarify the amount and timing of the deemed distribution.

Under the current regulations, it is unclear whether a holder that receives additional rights to acquire stock must include in income the fair market value of the right or the fair market value of the underlying stock itself. The proposed regulations clarify that a deemed distribution of rights to acquire stock is best viewed as a distribution of additional rights to acquire stock, the amount of which is the fair market value of the right itself. However, the preamble states that, for deemed distributions that occur before final regulations are published, the IRS will not challenge taxpayers that use the fair market value of the underlying stock.

The proposed regulations also clarify that the timing of a deemed distribution that results from a conversion adjustment is the time the adjustment occurs, in accordance with the terms of the instrument, but in no event later than the actual distribution that triggers the adjustment.

Deemed distributions that result in taxable income to non-U.S. holders of convertible securities pose challenges to withholding agents, who are obligated to withhold and remit tax even though holders do not receive a cash payment. The proposed regulations provide a limited exception for withholding agents, who would not be required to withhold on deemed distributions unless either (i) the issuer of the instrument satisfies its reporting obligations with respect to the deemed distribution (for example, by providing notice to holders or by posting information on its website) or (ii) the withholding agent has actual knowledge of the deemed distribution.

IRS Backtracks on Recent "Bad Boy" Guarantee Memorandum

Earlier this year, a legal memorandum by the Internal Revenue Service ("IRS") Office of Chief Counsel, CCA 201606027 (the "Memorandum"), concluded that a so-called "bad boy guarantee" provided by a sponsor of a real estate partnership could cause an otherwise non-recourse financing to be treated as recourse for tax purposes. The Memorandum came as a surprise to many in the real estate community as taxpayers typically have treated otherwise non-recourse loans as non-recourse for partnership basis and loss allocation purposes even if there was a bad boy guarantee, given the low risk that the events triggering the guarantee obligation would occur.

Whether partnership liabilities are characterized as recourse or non-recourse is important because a partner's tax basis in its partnership interest includes the partner's share of partnership liabilities. A nonrecourse liability of the partnership generally increases the tax basis and at-risk investment of each of the partners in proportion to their share of profits or capital, whereas a recourse liability only increases the tax basis and at-risk investment of the partner who bears the risk of loss with respect to the liability. Liabilities are treated as being recourse to a partner if that partner bears the so-called "risk of loss" in the event that the partnership fails to satisfy the liability. In determining whether a partner bears the risk of loss with respect to a partnership liability, the partnership tax rules look to whether a partner has an obligation to repay the liability upon a constructive liquidation of the partnership, taking into account all statutory and contractual obligations (including a partner's guarantee of the debt). However, under Treas. Reg. Section 1.752- 2(b)(4), a partner's guarantee obligation is disregarded "if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged" (a "Disregarded Guarantee"). Further, if an "obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs."

In the Memorandum, partnership X and its subsidiaries incurred several non-recourse loans (the "Loans"). In connection with the loans, one of X's members (the "Guarantee Partner") entered into a personal guarantee (the "Guarantee") that would be triggered upon any of the following conditions (the "Conditions"):

  1. The co-borrowers fail to obtain the lender's consent before obtaining subordinate financing or transfer of the secured property;
  2. Any co-borrower files a voluntary bankruptcy petition;
  3. Any person in control of any co-borrower files an involuntary bankruptcy petition against a coborrower;
  4. Any person in control of any co-borrower solicits other creditors to file an involuntary bankruptcy petition against a co-borrower;
  5. Any co-borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding;
  6. Any person in control of any co-borrower consents to the appointment of a receiver or custodian of assets; or
  7. Any co-borrower makes an assignment for the benefit of creditors or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due.

In analyzing the loan, the IRS concluded that, generally, a bona fide guarantee that is enforceable under local law is sufficient to cause the guaranteeing partner to be treated as bearing the risk of loss with respect to the applicable liability. In addition, the IRS argued that upon a constructive liquidation of partnership X, it would be reasonable to assume that one or more of the Conditions, more likely than not, would be met, in which case the Guarantee Partner would be personally liable to repay the Loans. Thus, the IRS concluded that the Guarantee was not a Disregarded Guarantee, and the Loans should be treated as recourse liabilities for partnership tax purposes and should only increase the tax basis and at-risk investment of the Guarantee Partner.6

However, recently the IRS released AM 2016-001, which represents a reversal of the prior Memorandum, and the IRS' reasoning now aligns with the industry practice of treating these bad boy guarantees as contingencies unlikely to occur that are disregarded under Treas. Reg. Section 1.752-2(b)(4). In AM 2016- 001, the IRS considers the same bad boy guarantees as the prior Memorandum and concludes that an important aspect of these carve-outs is that the bad acts that they seek to prevent are within the control of guarantor. The IRS reasons, because it is in the economic self-interest of the guarantor to avoid committing the bad acts and subjecting itself to liability, the guarantor is unlikely to voluntarily commit such acts. However, the IRS explains that condition #7 deserves a further discussion because it could be interpreted as giving the lender the ability to cause the guarantor to commit one of the bad acts. For example, if a loan agreement required the borrower to provide the lender with periodic written financial reports, and those reports revealed that the borrower was insolvent, the lender might argue that those reports constituted a written admission of insolvency.

The IRS suggests this is an inappropriate interpretation of such an event because, in the commercial real estate finance industry, bad boy guarantees are not intended to allow the lender to require an involuntary action by the guarantor or place the guarantors in circumstances that would require them to involuntarily commit a "bad act." Rather, the fundamental business purposes behind these carve outs and the intent of the parties to such agreements is to prevent actions by the guarantor that could make recovery on the debt more difficult. Thus, the IRS concludes, bad boy guarantees should be interpreted consistently with that purpose and intent in mind, and because it is not in the economic interest of the guarantor to commit the bad acts described in the typical bad boy guarantees, it is unlikely that the contingency (the bad act) will occur and the contingent payment obligation should be disregarded under Treas. Reg. Section 1.752-2(b)(4). Therefore, unless the facts and circumstances indicate otherwise, a typical bad boy guarantee provision that allows the guarantor to avoid committing the enumerated bad act will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of Treas. Reg. Sections 752 and 1.752-2(a) until such time as the contingency actually occurs.

FAA 20161101F: Low-Risk Tax Credit Partnership Investor Isn't Bona Fide Partner

In a heavily redacted Field Attorney Advice Memorandum (FFA 20161101F), the IRS concluded that a taxpayer did not own a bona fide partnership interest in an investment that allocated to the taxpayer Section 45 refined coal credits. The investment involved a limited liability company (LLC) taxed as a partnership that owned and operated a facility that produced refined coal. Under the LLC agreement, the taxpayer was allocated future refined coal tax credits and was obligated to make future contributions contingent on the amount of coal produced, and by extension, the amount of tax credits generated. Furthermore, the LLC agreement indemnified the taxpayer in the event that the tax credits were disallowed.

The IRS used the Culbertson7 test to examine whether the investment was a bona fide partnership interest for U.S. federal income tax purposes. Under the Culbertson test, an interest in an entity constitutes a partnership interest if, based on the facts and circumstances, the parties intended to join together in the present conduct of the enterprise. In looking beyond the form of the transaction and instead examining the facts and circumstances, the IRS referred to various cases, including Historic Boardwalk Hall, LLC v. Commissioner.8 Factors such as contributions contingent on the production of coal and the tax credit indemnification supported a finding that the taxpayer lacked entrepreneurial risk and upside potential separate from receipt of the tax credits. Furthermore, the promotional materials provided by the parties strongly indicated that the parties were not interested in a joint endeavor to operate a profitable refined coal facility. The materials stated that the taxpayer was not expected to be "out-of-pocket" from the investment and calculated the taxpayer's benefits based on the tax benefit instead of any expectation of profit from the production of the refined coal. Finally, the IRS determined that the relationship between the parties was akin to a buyer and seller of tax credits, which also supported a finding that the taxpayer was not a bona fide partner. Based on these facts and circumstances, the IRS concluded that a taxpayer did not own a bona fide partnership interest.

PLR 201614026 Putting Bearer Student Loans Into a Limited Partnership to Create Registered Instruments for Federal Income Tax Purposes

Recent Private Letter Ruling 201614026 provided some guidance on whether interests held in a partnership that acquires and holds student loans be considered obligations in registered form. Section 163(f)(1) disallows a deduction for interest on any registration required obligation unless the obligation is in registered form. Section 1.871-14(a) provides, subject to some exceptions, no tax shall be imposed on interest paid to a non-U.S. person on an obligation in registered form. Thus, the answer to the question has important consequences for a foreign investor's ability to qualify for the portfolio interest exemption. According to Section 5f.104-1(c)(1), an obligation is considered in registered form if:

  1. the obligation is registered as to both principal and stated interest with the issuer (or its agent) and transfer of the obligation may be effected only by surrender of the old instrument to the issuer in exchange for a new instrument or a reissuance by the issuer of the old instrument to a new holder;
  2. the right to the principal of, and stated interest on, the obligation may be transferred only through a book entry system maintained by the issuer (or its agent); or
  3. the obligation is registered as to both principal and stated interest with the issuer (or its agent) and may be transferred through most of the methods described in (i) and (ii) above.

Section 5f.103-1(c)(2) provides that an obligation will be considered transferable through a book entry system if the ownership of an interest in the obligation is required to be reflected in a book entry which is a record of ownership that identifies the owner of an interest in the obligation. With respect to an interest in a grantor trust holding a pool of mortgage loans, Section 1.1635T(d)(1) provides that an interest (a "pass-through certificate") in a trust that is treated as a grantor trust is considered to be an obligation in registered form if the pass-through certificate is in registered form "without regard to whether any obligation held by the fund or trust to which the pass-through certificate relates" is in registered form. Thus, the "registration required obligation" is the certificate evidencing the interest in the entity rather than the underlying obligations.

PLR 201614026 involved a Taxpayer that used capital contributions from its owners to acquire interests in a limited partnership (the "Partnership") that would have the ability to acquire student loans and use principal pay downs on the loans it held to finance acquisitions of additional student loans. These student loans were not in registered form within the meaning of Section 5f.103- 1(c); however, the interests in the Partnership were only transferable pursuant to procedures described in 5f.103- 1(c)(1). For instance, under the terms of the limited partnership agreement, the general partner was obligated to keep a full and accurate register of the interests in the Partnership and only those persons that appeared on this register would be entitled to a distributive share of the Partnership's income with respect to the student loans. In addition, interests in the Partnership could only be transferred on the written consent of the general partner. Thus, the Partnership interests were similar to the pass-through certificate of a mortgage pool, except the Partnership was not treated as a grantor trust. Nevertheless, the PLR concluded that interests in a limited partnership were similar evidences of interest in a similar pooled fund under Reg. 1.163-5T(d)(1), and such interests would be considered obligations in registered form if the requirements of Section 5f.103-1(c)(1) were satisfied.

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Footnotes

1 This follows last fall's avalanche of Treasury regulations, see Tax Talk Volume 8 Issues 3, available at http://www.mofo.com/~/media/Files/Newsletter/2015/11/151103TaxTalk.pdf.

2 All section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.

3 Our Client Alert on the proposed Section 385 regulations is available at http://www.mofo.com/~/media/Files/ClientAlert/2016/04/160412IRSDebtEquityRegulations.pdf.

4 See Marie Sapirie, Altera Alters the Landscape for Reg Challenges, Tax Notes Today 2015 TNT 158-1, (Aug. 17, 2015); Susan Simmons, Year in Review: Altera Changes the Game, Tax Notes Today, 2015 TNT 248-4 (Dec. 28, 2015); Michael L. Schler, Altera and the Proposed Debt-Equity Regulations, Tax Notes Today2016 TNT 84-13, (May 2, 2016).

5 Altera Corporation and Subsidiaries v. Commissioner, 145 T.C. No. 3 (2015).

6 For a fuller discussion of CCA 201606027, see http://www.mofo.com/~/media/Files/ClientAlert/2160322BadBoyGuarantees.pdf.

7 Commissioner v. Culbertson, 337 U.S. 733 (1949).

8 Historic Boardwalk Hall, LLC v. Commissioner, 694 F.3d 425 (3d Cir. 2012).

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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