Welcome to Tax Talk 9.02. By this fall, we may look back on Q2 2016 with some nostalgia. Of course, there is the U.S. presidential election on November 8th, but U.S. tax advisors right now are more focused on the proposed Section 3851 debt-equity regulations released in early April. Despite over 100 comment letters and a three-hour public hearing on July 14, 2016, U.S. Treasury Department officials have not budged from their plan to release final regulations after Labor Day. Once they do, some debt instruments will only have 90 days to live before they are recharacterized as equity for federal income tax purposes. And that's just one of the features of the proposed regulations which have been roundly criticized from every angle. Lost in the shuffle, however, was an IRS announcement2 that any challenge to a taxpayer brought under the regulations once they are final (assuming they become final) needs an additional layer of approval—the IRS Associate Chief Counsel. This reminds us of the Treas. Reg. §1.702-2 partnership anti-abuse rule and the codification of the economic substance doctrine where similar requirements exist.3 A cynic might say the government gets the most out of the regulations like these when taxpayers simply don't do their transactions. If the government allowed its audit teams unbridled ability to assert the regulations, they would bring lots of cases, not all of them strong ones. This would also provide taxpayers more incentive and more opportunities to challenge the regulations. If a taxpayer won, that could begin to undermine the entire effort. But by restricting audit team access to the provision, the government achieves the desired "in terrorem" effect with less risk of a successful taxpayer challenge. The government understands quite well that few taxpayers have the gumption (and resources) to bet the ranch on tax litigation. Having said that, you might be willing to bet the ranch (and a whole lot more) on a taxpayer challenging these particular regulations in the future if they are finalized.4 We'll be reporting on that in Tax Talk 15.04.
Back to Tax Talk 9.02, however, we cover the fallout from the proposed Section 385 regulations in detail. We also cover proposed changes to the model qualified intermediary agreement, proposed regulations for disregarded entities wholly owned by foreign persons, the Republican tax reform plan, and more.
Section 385 Update: Comment Letters and Politics
On April 4, 2016, the Treasury Department issued proposed regulations under Section 385 (the "Proposed Regulations") which could dramatically change how related-party indebtedness is treated for federal income tax purposes. As expected, the Proposed Regulations were immediately controversial and, as of July 12, have provoked at least 115 comment letters5 that the Treasury Department will have to consider before making the regulations final. In particular, several commentators provided the Treasury Department with extensive comments on the Proposed Regulations which (1) authorize the IRS to bifurcate an instrument into part-equity and part-debt (the "Bifurcation Rules"), (2) impose documentation requirements for certain relatedparty indebtedness to be respected as indebtedness for federal income tax purposes (the "Documentation Rules"), and (3) automatically treat debt instruments as equity for federal income tax purposes if they are issued in situations that the Treasury Department views as having limited non-tax effect (the "Automatic Equity Rules").
The New York State Bar Association issued a report outlining comments and criticisms of various aspects of the Proposed Regulations. The report acknowledges that the primary aims of the Proposed Regulations include limiting earnings, stripping transactions, and the use of intercompany transactions to repatriate offshore earnings without current U.S. tax. However, the report cautions that the Proposed Regulations would have "significant and disruptive effects on ordinary commercial activities" and act as a trap for the unwary for taxpayers that were not well advised. The report makes specific recommendations on the Proposed Regulations. For example, the report suggests that the Bifurcation Rules may cause administrative difficulty because the Proposed Regulations do not provide guidance on how a single debt instrument should be bifurcated into part-debt and part-equity for tax purposes, or what values should be ascribed to the pieces. The report recommends that the Bifurcation Rules be narrowed to situations involving overleveraged members of a multinational group. Although the report generally approves of the substance of the Documentation Rules, the report recommends administrative changes to make the rules more workable, such as amending the deadlines for the appropriate documentation. The report raises "serious concerns" about the Automatic Equity Rules and "strongly recommend[s] against issuing this proposed regulation in final form." Generally, the report identifies the Automatic Equity Rules as being both over- and under-inclusive and producing "arbitrary results." The report recommends a number of alternatives to the Automatic Equity rules, including provisions that are more targeted to inverted companies, guidance based on a group's third-party debt-equity ratio, or significantly narrowing the scope of the Automatic Equity Rules.
The Securities Industry and Financial Market Association ("SIFMA") also submitted comments to the Treasury Department that requested exceptions from the Proposed Regulations for financial institutions. In particular, the comments point out that, in order to effectively satisfy its role as an intermediary, a financial institution must be able to move funds quickly between jurisdictions, including through the use of intercompany loans. Furthermore, SIFMA argues that financial institutions are already subject to significant regulation that impose economic discipline on members of a financial group. The SIFMA letter generally requests that members of a regulated financial group should not be subject to the Automatic Equity Rules, or at least should be granted specific exceptions in certain situations. Furthermore, the comments recommend easing the requirements of the Documentation Rules and softening the consequences for failure to comply with the Documentation Rules, as well as delaying the effective date of the Proposed Regulations to give financial institutions more time to comply.
Republican members of the House Ways and Means Committee wrote a letter to Treasury Secretary Jacob Lew expressing "grave concerns" over the Proposed Regulations. In particular, the letter criticizes the Proposed Regulations as "broadly applicable to a wide array of ordinary business transactions, creating unacceptably high levels of uncertainty and adverse collateral consequences for non-tax motivated business activity." The letter also cautions that, because earnings stripping and inversion transactions are dealt with in other parts of the Internal Revenue Code, the Proposed Regulations have co-opted Section 385 for uses other than what Congress intended. Senator Bernie Sanders (I-VT) however, supports the regulations and stated that the proposed rules "focus only on the most blatant abuses."
Although it is impossible to tell whether and to what extent the Treasury Department will address the concerns raised in these comment letters, there is some evidence that these criticisms have not gone unnoticed. On July 16, Treasury deputy assistant secretary Robert Stack acknowledged that the Proposed Regulations were a "blunt instrument" that "might have overdone it" with respect to cash pooling arrangements, foreign-to-foreign intragroup loans, and transactions by banks and S corporations. Taxpayers eagerly await the next piece of guidance by the Treasury Department, with particular attention paid to the effective date of any final regulations.
PLR 201614009: REIT's Like-Kind Exchanges Not Sales for Prohibited Transaction Safe Harbor
In Private Letter Ruling 2016-14-014, the IRS considered the application of Section 857(b)(6)(C). Section 857(b)(6)(C) provides a safe harbor from the 100% REIT excise tax on net income from "prohibited transactions." Generally, a prohibited transaction is a sale or other disposition of dealer property (i.e., any property held by a REIT primarily for sale to customers in the ordinary course of business) that is not foreclosure property. One of the safe harbors generally limits a REIT to no more than seven sales each year. In Private Letter Ruling 2016-22-009, a self-administered and self-managed REIT proposes to engage in a series of dispositions to realign its portfolio of properties including outright sales, like-kind exchanges under Section 1031 (some of which included boot), and asset sales. The IRS reasoned that Section 1031 transactions are consistent with the Congressional intent of the safe harbor to allow REITs to modify their portfolios without incurring the excise tax and held that Section 1031 exchanges are not treated as a sale for prohibited transaction purposes. The IRS held that each of the proposed 1031 like-kind exchange, would not be treated as a sale for purposes of the prohibited transactions limitation but, to the extent that gain is recognized by the REIT on boot received, that portion of the 1031 transaction may be treated as a sale for purposes of the safe harbor. This is similar to past private letter rulings such as PLR 2007-02-021.
Proposed Changes to Qualified Intermediary Agreement
On July 1, 2016, the IRS issued Notice 2016-42 proposing changes to the model Qualified Intermediary ("QI") agreement published in Rev. Proc. 2014-39 that expires on December 31, 2016. Generally, a QI is a qualifying entity (typically a foreign bank or other foreign financial institution) that is a party to a withholding agreement with the IRS. A QI provides a QI certificate to the IRS (Form W-8IMY) in which the QI may agree to undertake responsibility for income reporting and tax withholding on payments to beneficial owners of payments made to that entity. As a result, payments made to the QI do not require withholding. Thus, the QI assumes certain documentation and withholding responsibilities in exchange for simplified information reporting for its foreign account holders and the ability not to disclose proprietary account holder information to a withholding agent that might be a competitor.
Most importantly, the new proposed QI agreement in Notice 2016-42 provides guidance and operational procedures for implementing the new qualified derivative dealer ("QDD") regime under the final Section 871(m) regulations.6 The issue the regime addresses is the possibility of cascading withholding: if a foreign bank holds U.S. stock and enters into a derivative contract with respect to that stock with another foreign bank, it would generally be subject to withholding tax on dividends paid on the stock and would also have to withhold on payments made under the derivative contract.
Under the Section 871(m) regulations, generally, payments made to a foreign securities dealer or a foreign bank on U.S.-source dividend equivalent payments are subject to withholding. The Section 871(m) regulations allow foreign securities dealers and foreign banks to avoid being subject to withholding by agreeing to assume primary withholding and reporting responsibility when those amounts are then paid to their customers. In order to act as a QDD, an entity must (1) furnish to withholding agents a QI withholding certificate affirming that the recipient is acting as a QDD for dividends and dividend equivalents; (2) agree to assume primary withholding and reporting responsibilities on all payments associated with the withholding certificate the QDD receives and makes as dealer; (3) agree to remain liable for tax on any dividends and dividend equivalents it receives unless the QDD is obligated to make an offsetting dividend equivalent payment as the short party on the same securities; and (4) comply with any compliance review procedures that are applicable to a QI acting as a QDD, as specified in the QI agreement.
In Notice 2016-42, the IRS proposes changes to the QI agreement to allow a QI that is an eligible entity7 to act as a QDD. The proposed QI agreement provides that a QI may only act as a QDD for payments on potential 871(m) transactions or underlying securities that it receives and payments regarding potential 871(m) transactions that it makes as principal, regardless of whether those payments are received or made in the QDD's capacity as a dealer.
A QDD (other than a foreign branch of a U.S. financial institution) must determine and pay its "QDD tax liability," which is the sum of a QDD's liability under Sections 871(a) and 881 for (1) its "section 871(m) amount"; (2) its dividends that are not on underlying securities associated with potential Section 871(m) transactions and its dividend equivalent payments received as a QDD in its non-dealer capacity; and (3) any other U.S.-source fixed and determinable annual and periodic income payments received as a QDD with respect to potential Section 871(m) transactions or underlying securities that are not dividend or dividend equivalent payments. For this purpose, the QDD's "section 871(m) amount" is the excess of its dividends and dividend equivalent payments received in a dealer capacity over the sum of dividend equivalent payments made in its dealer capacity and the amount of dividend equivalent payments the QDD is contractually obligated to make acting as a QDD in dealer capacity. A QDD will have to report its tax liability on Form 1042 and make any required payments and deposits with respect to its tax liability.
If finalized, the proposed changes will apply to QI agreements in effect after December 31, 2016. The IRS intends to modify the Section 871(m) regulations to coordinate with the provisions of the proposed QI agreement relevant to the requirements of QDDs and withholding agents making payments to QDDs.
TD 9766: Partners in a Partnership Owning a DRE Subject to Self- Employment Tax
Under Treasury Regulations Section 301.7701-2(b), a business entity that has a single owner can elect to be treated as disregarded as an entity separate from its owner for federal income tax purposes (a "DRE"). Treasury Regulations Section 301.7701-2(c)(2)(iv)(B) provides an exception to this status and states that a DRE is treated as a corporation for purposes of federal employment taxes. Thus, the DRE rather than the owner is considered to be the employer of the DRE's employees for federal employment tax purposes. However, Treasury Regulations Section 301.7701-2(c)(2)(iv)(C) (2) provides that a DRE is not treated as a corporation for selfemployment tax purposes. The Regulations contain an example illustrating the mechanics of this rule; however, none of the examples include a DRE owned by a partnership. Because the Regulations do not mention disregarded entities owned by partnerships, some taxpayers have taken the position that the Regulations permit the treatment of individual partners in a partnership that own a DRE as employees of the DRE. This reading might allow a taxpayer to circumvent the IRS' position in Rev. Rul. 69-184 that partners in a partnership cannot also be employees of the partnership and, in turn, permit partners to participate in certain tax-favored employee benefit plans.
One May 4, 2016, the IRS issued Temporary Regulations to clarify that the self-employment tax rule of Treasury Regulations Section 301.7701-2(c)(2)(iv)(C)(2) also applies when a DRE is owned by a partnership. Thus under the new Temporary Regulations, a DRE owned by a partnership is not treated as a corporation, and the partners of the partnership are subject to the selfemployment tax.
In the Preamble to the Temporary Regulations, the IRS noted its belief that that the existing Regulations did not create a distinction between a DRE owned by an individual and a DRE owned by a partnership in the application of the self-employment tax rule. In addition, the IRS does not believe the existing Regulations alter the holding of Rev. Rul. 69-184 which provides that: 1) members of a partnership are not employees of the partnership for FICA, FUTA, or income tax withholding purposes; and 2) a partner who devotes time and energy in the conduct of the trade or business of the partnership is a self-employed individual rather than an employee. The Temporary Regulations will apply on the later of 1) Aug. 1, 2016, or 2) the first day of the latest starting plan year following May 4, 2016, of an affected plan sponsored by an entity that is a disregard entity.
Rev Proc 2016-31: Relief for Money Market Funds Receiving Amounts to Comply with New SEC Rules
The Internal Revenue Service has cleared the way for investment advisers to "top off" money market fund ("MMF") assets to bring them in compliance with the new rules that require certain funds to adopt "floating rate" structures beginning October 14, 2016. Rev. Proc. 2016-31 provides that receipt by a MMF of a contribution from an adviser by itself will not disqualify the MMF from relying on status as a "regulated investment company" under Section 852, or result in excise tax under Section 4982.
A MMF is an investment company registered under the Investment Company Act of 1940. Under existing rules, MMFs may maintain a fixed price of $1.00 per share by using the "amortized cost method" or "penny rounding method" of valuation.
In 2014, the SEC amended Rule 2a-7 to require MMFs other than those that limit their investors to natural persons (retail MMFs) or limit their investments to government securities (government MMFs) to adopt a floating-rate structure. That is, effective October 14, 2016, the net asset value ("NAV") of all MMFs other than retail MMFs and government MMFs will float up or down, depending on the market value of their portfolio holdings (floating rate MMFs).
It is expected that many investment advisers may want to contribute capital, so that when the MMF transitions to a floating NAV all shareholders receive the same value per share at the time of the transition (a top up contribution). However, the distribution requirements under Section 852 pose a potential hurdle to the use of top up contributions to raise an MMF's NAV to $1.0000. In order for an MMF to be taxed as a regulated investment company ("RIC"), the MMF must meet certain requirements detailed in Section 852. Section 852(a)(1) requires the MMF's deduction for dividends paid to equal or exceed 1) the sum of 90% of the RIC's investment company taxable income ("ICTI") for the tax year, and 2) 90% of the excess of the RIC's interest income excludable from gross income under Section 103(a) over the RIC's deductions disallowed under Section 265 and Section 171(a)(2). In addition, Section 852(b)(1) imposes a tax on a RIC's ICTI, which is taxable income excluding net capital gain and deductions for dividends paid.
If the distribution requirements of Section 852(a) apply to a top up contribution, it may be impossible for the advisers of MMFs to make contributions that raise an MMF's NAV. To increase the value of an MMF's portfolio by a given amount, an adviser would need to contribute more than ten times that amount to "gross up" the contribution for both a 90% distribution requirement and tax on the undistributed amount.
To facilitate a smooth transition to compliance with the new SEC MMF rules, on May 23, 2016 the IRS issued Rev Proc 2016-31 which provides temporary relief for certain MMFs that receive contributions from their advisers as the MMF transitions to comply with the new SEC rule. Under Rev Proc 2016-31, certain adviser contributions are excluded from ICTI for purposes of the distribution requirements of Section 852(a); however, the contributions are still included in the RIC's income for other federal tax purposes including Section 852(b). Rev Proc 2016-31 applies to a top up contribution that is received by an MMF as part of a transition to implement the floating NAV reform before the Oct. 14, 2016, compliance deadline. If an MMF receives such a contribution, the IRS will not challenge the MMF's treatment of the contribution as an amount that is included in ICTI for purposes of Code Sec. 852(b) but is excluded from ICTI for purposes of Code Sec. 852(a)(1). Rev Proc 2016-31 is effective for all contributions that are described in the Rev Proc.
T.D. 9771: Final Regulations on the Application of the Section 108 Bankruptcy and Insolvency Exclusions to Grantor Trusts and DREs
On June 10, 2016, the IRS issued final regulations (the "Regulations") that provide guidance on how the exclusion from gross income of cancellation of debt income ("CODI") applies in the case of debt issued by a taxpayer's DRE or grantor trust.
Under general tax principles, a debtor that incurs indebtedness does not include the debt proceeds in income because the taxpayer incurs an offsetting obligation to repay the indebtedness. As a result, if the taxpayer is relieved of the obligation to repay the indebtedness, the taxpayer is required to include CODI in income.
Section 108 of the Code provides exceptions to the general rule that CODI is included in a taxpayer's income. Two exceptions found in Section 108 apply if the taxpayer is in bankruptcy or the taxpayer is insolvent. While applications of the Section 108 exclusions can be relatively straightforward in the case of indebtedness incurred by a taxpayer directly, it has been unclear whether Section 108 applies to a taxpayer that incurs CODI as a result of debt issued by the taxpayer's DRE or grantor trust where the entity (but not the taxpayer himself/herself) is bankrupt or insolvent.
The Regulations provide that the bankruptcy exclusion is available to a taxpayer only if the taxpayer is the debtor in bankruptcy and that it is insufficient if the taxpayer's DRE or grantor trust is in bankruptcy. According to the preamble of the Regulations, "Congress did not intend that a solvent, non-debtor owner of a grantor trust or a disregarded entity, which has committed some but not all of its nonexempt assets to the bankruptcy court's jurisdiction, have an exclusion from discharge of indebtedness income merely by virtue of having some of its assets subject to the jurisdiction of the bankruptcy court." Where the grantor trust or DRE is owned by a partnership, the Regulations provide that the partner(s) to whom the income is allocable must be in bankruptcy.
While the Regulations provided some clarity on the Section 108 bankruptcy exception, the Regulations declined to explicitly promulgate a rule that addressed how indebtedness of a DRE or grantor trust is taken into account in determining the extent to which a taxpayer is insolvent. For example, it is unclear whether indebtedness issued by a taxpayer's DRE or grantor trust that is nominally recourse with respect to the DRE or grantor trust should be considered recourse indebtedness or, because the entity's creditors can only look to the assets owned by the entity itself, the indebtedness should be viewed as nonrecourse as to the taxpayer. Although the Regulations do not contain a rule addressing these issues, the preamble to the Regulations states that it is the IRS's view that indebtedness of a DRE or grantor trust is indebtedness of its owner for tax purposes and, unless the owner has guaranteed the debt or is otherwise liable for the debt, the debt should be viewed as nonrecourse. According to the preamble, the IRS is continuing to study these issues and anticipate publishing additional guidance in the future.
Proposed Regulations on Foreign-Owned DREs
On May 10, 2016, the IRS proposed new regulations that would generally treat a DRE wholly owned by a foreign person as a domestic corporation separate from its owner for the limited purposes of reporting, record maintenance, and associated compliance requirements under Code Section 6038A.8 Under current law, certain U.S. entities treated as DREs by default, rather than by an election, do not generally need to acquire a U.S. employer identification number, or EIN. However, the DRE rules in Treas. Reg. Section 301.7701-2(c) treat a DRE as separate from its owner for the limited purposes of employment and excise taxes. The proposed regulations would add DREs wholly owned by a foreign person to this exception. As a result, these DREs would be treated as foreign-owned domestic corporations separate from their owners for the purposes of information reporting, and affected entities would be required to file the Form 5472 information return with respect to transactions reportable under 6038A9 between the entity and its foreign owner. Additionally, affected entities would be required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions.
Interestingly, the proposed regulations would impose a filing obligation on a foreign-owned disregarded entity for transactions reportable under Section 6038A even if the entity's foreign owner already has an obligation to report the income resulting from those transactions. For example, if a foreign-owned disregarded entity engages in a transaction reportable under Section 6038A that is also a transaction effectively connected with a U.S. trade or business, the owner would already have an obligation to report that transaction on his or her tax return, but the proposed regulations would require that owner to also file a Form 5472 information return for those transactions.
An affected entity required to file Form 5472 under the regulations would be liable for penalties of at least $10,000 for each Form 5472 that is not filed or is filed inaccurately. The proposed regulations would be effective for taxable years ending on or after the date that is 12 months after the date the regulations are published as final in the Federal Register.
To see this newsletter in full, please click here.
1 All section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
2 I.R.S. Notice CC-2016-009 (June 30, 2016), as revised July 25, 2016. See Amy S. Elliott, Debt-Equity Challenges Must Get Associate Office Review, 2016 TNT 144-1 (July 27, 2016).
3 See IRS Announcement 94-87, 1994-27 I.R.B. 1(June 13, 1994) (partnership anti-abuse announcement); I.R.C. Section 7701(o) (codified economic substance doctrine); I.R.S. Directive LB&I-4-0711-015 (July 15, 2011) (limiting when I.R.S. examining agents can assert the penalty for failure to meet the codified economic substance doctrine).
4 On August 4, the U.S. Chamber of Commerce and the Texas Association of Business filed a lawsuit seeking to overturn an aspect of the "inversion" targeted regulations issued at the same time as the Section 385 regulations (generally, an effort by the government to prevent U.S. parent corporations from shifting to foreign-parent structures). See Complaint, Chamber of Commerce of the United States of America et al. v. IRS et al.; No. 1:16-cv-00944 (W.D. Tex. Aug. 4, 2016).
5 Collected Comments on Proposed Regs: Debt-Equity, 2016 TNT 134-34 (July 12, 2016).
6 For a more detailed discussion of the final Section 871(m) regulations, see our Client Alert, available at http://www.mofo.com/~/media/Files/ClientAlert/2015/09/150921DividendEquivalent.pdf.
7 For this purpose, an "eligible entity" includes (1) government-regulated securities dealers; (2) governmentregulated banks that issue potential 871(m) transactions to customers and receive dividends or dividend equivalent payments pursuant to such transactions; or (3) entities wholly-owned by an entity described in (2).
8 Generally, Section 6038A imposes reporting and recordkeeping requirements on domestic corporations that are 25percent foreign owned. Under that section, such a domestic corporation must file Form 5472 for each related party with which the reporting corporation has had any reportable transactions.
9 A "reportable transaction" is generally defined in the Regulations as either a foreign related party transaction for which only monetary consideration is paid or received by the reporting corporation, or a foreign related party transaction involving nonmonetary consideration or less than full consideration.
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