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.

To continue reading this article, please click here.

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

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Anna Pinedo
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions