EDITOR'S NOTE

Although 2015 is already under way, we can't quite ring in the new year without sharing some of the more noteworthy tax items of Q4 2014 (and, admittedly, a few from this year as well) in this issue of Tax Talk.

Predictably, as 2014 drew to a close, Congress was busy trying to squeeze in a few last-minute tax bills. With just days left in the year, the 113th Congress passed legislation to extend a number of important tax breaks that were slated to expire at the end of 2013. And, as the New Year dawned and the 114th Congress gathered in Washington, D.C., House Republicans muscled through new rule changes designed to impact the way legislation would be evaluated— so-called "dynamic scoring." Indeed, with a GOP-majority in the House and Senate, it remains to be seen whether Republicans will be able to galvanize and begin the process of passing comprehensive tax reform. We bring you the salient details below.

Turning from the political to the substantive, this issue of Tax Talk also highlights IRS private guidance that addresses REITs, which continued to be hot in 2014. On the international tax front, we also summarize IRS private guidance that holds that a foreign fund engaged in lending and stock distribution could not take advantage of the "trading in stock or securities" safe harbor, as well as guidance that recharacterizes certain loans among related companies for purposes of the Section 956 income inclusion rules. Finally, we conclude Tax Talk with a few developments that impact the taxation of financial instruments and our usual column, MoFo in the News.

CONGRESS PASSES YEAREND TAX EXTENDERS BILL

On December 19, just days before the end of 2014, President Obama signed into law the Tax Increase Prevention Act of 2014 (TIPA). TIPA retroactively extended a number of tax breaks for 2014 that had expired at the end of 2013. While we won't bore our readers by reciting chapter and verse, there are a few key provisions of the tax extender's bill worth mentioning. Specifically, taxpayers will still enjoy the benefit of the following tax breaks for 2014:

  • bonus depreciation;
  • certain interest-related and short-term capital gain dividends from a RIC;
  • RIC-qualified investment entity treatment under FIRPTA;
  • subpart F exception for active financing income;
  • look-thru treatment of payments between related controlled foreign corporations under foreign personal holding company rules; and
  • temporary exclusion of 100% of gain on certain small business stock.

HOUSE ADOPTS NEW "DYNAMIC SCORING" RULE

On January 6, 2015, House Republicans pushed through a new rule that would require more macroeconomic projections be included by the Congressional Budget Office and Joint Committee on Taxation when providing cost estimates for major legislation. This new methodology, referred to as "dynamic scoring," essentially requires budget estimates to also take into account how the proposed legislation could impact the economy at large. While the rule only affects House bills, it has drawn wide-spread criticism from Democrats and the White House. These critics claim that the new rule will make it easier to pass legislation that could increase the deficit, while simultaneously making it more difficult to determine the legislation's cost. In other words, Democrats cry that dynamic scoring will only make it easier for Republicans to pass tax cuts, without disclosing the true financial impact of the cuts in a "fair" and "accurate" manner. While the immediate impact of the new rule remains to be seen, with Republicans in control of Congress, one can only speculate whether it will be the platform from which the GOP will attempt to launch a series of bills designed to overhaul the tax code.

FOREIGN FUND ENGAGED IN LENDING AND STOCK DISTRIBUTION NOT PROTECTED BY "TRADING IN STOCK OR SECURITIES" SAFE HARBOR

For decades, U.S. taxpayers (or non-taxpayers) have been bedeviled by the distinction between trading in stocks and securities and lending. Today, many foreign corporations purchase bank loans in the secondary market. Over time, however, the distinction between secondary market purchase and loan origination has been tested as the foreign corporation steps closer and closer to the loan's origination. Much has been written about this; during the Financial Crisis, industry groups attempted to get the Treasury to loosen the rules but to no avail.

In CCA 201501013, the Office of the IRS Chief Counsel concluded that Fund, a foreign partnership, and Foreign Feeder, a foreign corporation and partner of (Fund), engaged in lending and stock distribution activities that qualified as a trade or business within the U.S., and that did not constitute "trading in stock or securities" under the Trading Safe Harbors (defined below).

Fund entered into a management agreement with Fund Manager under which Fund Manager acted as Fund's agent and maintained full power to buy, sell, and deal in securities and related contracts for Fund's accounts. Through an office in the U.S., Fund Manager conducted extensive lending and stock distribution/underwriting activities on behalf of Fund. Lending activities included conducting due diligence, negotiating with borrowers, and lending money in return for convertible debt instruments and promissory notes. Stock distribution/ underwriting activities included negotiating with issuers, purchasing stock at a discount from the issuers, and selling the stock to both U.S. and foreign investors.

Fund argued that the activities constituted investment activity and, thus, did not constitute a trade or business within the U.S. Fund also argued in the alternative that the activities fell within the Trading Safe Harbors.

First, the IRS concluded that Fund engaged in a trade or business within the U.S. Pursuant to Section 882, a foreign corporation that engages in a trade or business within the U.S. is taxable on its income that is effectively connected with such trade or business within the U.S. Activities performed by an agent on behalf of a foreign person are considered to be performed by the foreign person.1 To determine whether activities constitute a U.S. trade or business, courts and the IRS have applied a facts and circumstances test—the profit-oriented activities must be considerable, continuous, and regular. For instance, activities must go beyond passive management of investments.2 The IRS concluded that Fund's activities were considerable, continuous, and regular because Fund dedicated significant time, energy, and resources to making numerous loans to borrowers and entering into dozens of stock distribution agreements with issuers.

Second, the IRS concluded that Fund's activities did not constitute "trading in stocks or securities" and, thus, did not fall within the Trading Safe Harbors. Pursuant to Section 864(b), a trade or business within the U.S. does not include, inter alia, "trading in stock or securities." Section 864(b)(2)(A) include two safe harbors (the "Trading Safe Harbors") for which certain trading activities performed by or on behalf of a foreign person that would otherwise constitute a trade or business within the U.S. are considered not to be a trade or business within the U.S. The first Trading Safe Harbor (the "First Safe Harbor") provides that a trade or business within the U.S. does not include trading stocks or securities through a "resident broker, commission agent, custodian, or other independent agent."3 The First Safe Harbor does not apply if the foreign person has an office or fixed place of business in the U.S. The second Trading Safe Harbor (the "Second Safe Harbor") provides that a trade or business within the U.S. does not include "[t]rading in stocks or securities for a taxpayer's own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions."4 Unlike the First Safe Harbor, the Second Safe Harbor cannot be used by foreign dealers, but can be used by other foreign persons who have offices or fixed places of business in the U.S.

Pursuant to the Treasury Regulations for the Trading Safe Harbors, "trading in stock or securities" means "the effecting of transaction in stock or securities" including buying, selling or trading in stocks, securities, or contracts or options to buy stocks or securities.5 The IRS concluded that neither Fund's lending nor underwriting activities constitute "trading in stock or securities." The IRS referred to Treas. Reg. § 1.864-4(c)(5) to conclude that lending is not "trading in stock or securities" because a foreign person who makes a loan in the U.S. engages in the active conduct of banking or financing within the U.S. A narrow exception, which allows a foreign underwriter to qualify for the Trading Safe Harbors if it sells only to foreign buyers,6 does not apply to Fund, which sold shares to both U.S. and foreign buyers. Furthermore, courts have defined "trading" as profiting from fluctuations in the price of assets, as opposed to profiting from services provided.7 The IRS determined Fund's activities were not trading because Fund profited not from a change in value of securities but from earning fees, a spread, and interest on its lending and underwriting activities.

Alternatively, the IRS concluded that, even if Fund's lending and stock distribution activities were "trading in stock and securities," Fund could not have used the Trading Safe Harbors. The First Safe Harbor did not apply because Fund's management agreement provided discretionary authority to Fund Manager. The IRS concluded that the language of Section 864(b), its legislative history, and its regulations disallow protection under the First Safe Harbor if the taxpayer gives discretionary authority to a U.S. resident agent. Specifically, in the Foreign Investor's Tax Act of 1966 (P.L. 89-809) (FITA), Congress made two amendments to the safe harbor in the Internal Revenue Code of 1939 (the "1939 Safe Harbor"). The 1939 Safe Harbor permitted trading in the U.S. through a "resident broker, commission agent or custodian." FITA added "or other independent agent" to the 1939 Safe Harbor (now, the First Safe Harbor), and added the Second Safe Harbor, which expressly permits foreign non-dealers to trade through resident agents who have discretionary authority. Thus, the IRS concluded that by including discretionary authority in the Second Safe Harbor, the First Safe Harbor implicitly excludes discretionary authority from the meaning of independent agent.8 What's more, the Treasury Regulations provide an exception under the Second Safe Harbor where a foreign bank authorizes discretionary authority for a U.S. broker trading on behalf of the foreign bank's customers. If a foreign dealer could grant discretionary authority under the First Safe Harbor, then this narrow exception under the Second Safe Harbor would not be necessary. Thus, because Fund's management agreement provides for discretionary authority, the First Safe Harbor is not available to Fund.

Finally, the Second Safe Harbor did not apply to Fund because its underwriting activities fit within the definition of a "dealer in stock or securities." Pursuant to Treas. Reg. § 1.864-2(c)(2)(iv)(a), a dealer has an "established place of business" and "regularly engage[s] as a merchant in purchasing stocks or securities and sell[s] them to customers with a view of the gains and profits that may be derived therefrom." The IRS concluded that Fund had an established place of business and, through its underwriting activities, regularly engaged in purchasing stocks and selling them to customers with the intent of earning gains and profits.

In sum, the IRS determined that Fund and Foreign Feeder, as a partner of Fund, were engaged in a trade or business within the U.S. Fund's lending and stock distribution activities were considerable, continuous, and regular, and did not constitute "trading in stock and securities" under the Trading Safe Harbors.

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Footnotes

1. See Adda v. Commissioner, 10 T.C. 273, 277-78 (1948).

2. Higgins v. Commissioner, 312 U.S. 212 (1941).

3. IRC Section 864(b)(2)(A)(i).

4. IRC Section 864(b)(2)(A)(ii).

5. See Treas. Reg. § 1.864-2(c)(2).

6. Treas. Reg. § 1.864-2(c)(2)(iv)(b).

7. See, e.g., Bielfeldt v. Commissioner, 231 F.3d 1035 (7th Cir. 2000).

8. As a policy matter, Congress sought to prevent foreign dealers from gaining a competitive advantage—if the First Safe Harbor permitted discretionary authority, foreign dealers could directly compete with U.S. dealers while avoiding tax on their U.S. income.

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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