PLI LA 2011 2 - Viva Hammer Tax

Practising Law Institute
Financial Products and
Viva Hammer
KPMG, LLP -- Washington National Tax
Edward Kleinbard
USC Law School
Stephen R. Larson
IRS -- Associate Chief Counsel - FIP
December 2011
Los Angeles
Overview of proposed 1256/446 regulations
Enactment of Dodd-Frank Act and amendment to section 1256
Broadening scope of “notional principal contract”, other technical changes
Bullet swaps
Credit default swaps
Exotic swaps (weather swaps, longevity swaps)
Portfolio swaps
Futures/scope of section 1256
Effective date
Uncertain application of section 1256 to swaps subject to DoddFrank
 Section 1256 requires mark-to-market , capital gain/loss for “section
1256 contracts”
 Dodd-Frank requires swaps to be cleared through a central
counterparty (“clearinghouse”) and traded on regulated exchanges
Last-minute amendment to Dodd-Frank amended section 1256 to
clarify that certain swaps and “similar agreements” not included in
definition of section 1256 contract
Notional Principal Contract - definition
New proposed regs provide that Dodd-Frank amendment covers any
NPC or option on NPC
Proposed regs expand definition of NPC
 Taxation of NPCs provided for under prior regs
New proposed regs are proposed to be effective for contracts
entered into on or after final regulations are published
 Public statements by IRS that taxpayers need not adopt rules of
proposed regs before finalized e.g., CDS currently treated by some as
Bullet swaps
NPC definition requires at least one party to make more than one
“Payment” is defined in proposed regs to include “an amount that is
fixed on one date and paid . . . on a later date”
“Bullet swaps” — with a single payment at maturity calculated as
accumulation of amounts fixed during its term — treated as an NPC
Forward rate agreement is not a NPC
Forward contract on equity with interim accruals of dividend-and
interest-equivalent amounts is an NPC
Bullet swaps
“Payment” definition is novel - inconsistent with market practice and
conventional meaning of term “payment”
 Potential adverse consequences for individual investors, because of
miscellaneous itemized deduction rules
 Potential timing and character consequences for all taxpayers
 Possible effects on exchange-traded notes and other structured notes
 Possible effects on futures contracts
Bullet swaps
Preamble: Questions have arisen as to the proper interpretation of
the NPC definition requiring “payment of amounts”
Implies that there is uncertainty under current law on NPC definition.
 Possible “uncertainty” is whether multiple payments by one party are
 Possible “uncertainty” is as to proper treatment of bullet swaps, source
of uncertainty obscure.
 Meaning of term “payment” seems very clear; cf the OID regulations
 2004 proposed regulations contain several definitions consistent with
treating bullet swaps as non-NPCs
Credit default swaps
Uncertainty whether CDS should be: NPC, option, insurance,
Proposed regs CDS are NPCs; no definition of “credit default swap”
Options: no accrual, capital G/L, NPCs: current accrual, ordinary
Application of NPC timing/character rules to CDS unclear
 How to amortize upfront and settlement payments over life of CDS?
 Potential recharacterization of payments as interest
 Anticipated reproposed 2004 regulations will hopefully address these
issues and more generally interaction between 2011 proposed regs and
NPC timing rules
Exotic swaps
Proposed regs expand NPCs to include swaps on objective nonfinancial indices, if the index is not front- or back-loaded. E.g.,
weather swaps
Why limit non-financial indices to non-front- or back-loaded indices?
 OID rules can handle front- and back-loading and NPC rules already do
for caps and floors
 Many longevity swaps could be back-loaded
Effective Date issues
Proposed regs proposed to be effective for contracts entered into on
or after final regulations are published
How does Dodd-Frank exemption operate before finalization of
proposed regs?
Open Issues
What is a “payment” for purposes of the proposed regulations?
 What if the expected payment is zero, is that a fixed payment?
 For example, a contract that provides for a settlement payment
referenced to the appreciation or depreciation of a specified
number of shares of common stock, adjusted for actual dividends
paid during the term of the contract, is treated as a contract with
more than one payment with respect to that leg of the contract
 What if it is a non-dividend paying stock – does it still provide for 2
or more payments?
 Does an equity forward that contains an adjustment provision for
extraordinary dividends cause the plain vanilla equity contract to be
characterized as an NPC?
Open Issues
If the proposed regulations apply to CDS and bullet swaps, how
should the “payments” be treated for tax purposes?
 applicability of 2004 proposed NPC regulations
 4 approaches to accounting for contingent swaps as discussed in
Notice 2001-44
Open Issues
Clarification as to whether the proposed regulations apply to all CDS
or just CDS that are not otherwise classified for tax purposes as
options or guarantees
If new proposed regulations apply to bullet swaps or CDS that are
not currently treated as NPCs, how does a taxpayer change its
method of accounting?
Clarification surrounding definition of “non-financial index”
 Specifically, when can non-financial indices be reasonably expected
to front-load or back-load payments accruing under the contract?
Pritired 1 LLC v. United States
French Banks
$475M in 1% Convertible Notes
and $455M in Class A Shares
The Basic Economic Transaction:
U.S. partnership enters into co-investment transaction with a tax-indifferent foreign
investor. Through the transaction, foreign investor is able to borrow money at below
market rates. U.S. investor receives the benefit of claiming FTCs on the foreign
taxes paid on entire combined investment pool.
 In essence, the U.S. partnerships gives foreign investor a loan in exchange
for a small portion of income and all FTCs.
The Actual Transaction (simplified):
1. Taxpayers contributed $300M cash to newly formed Pritired 1 LLC (“Pritired”),
which had elected to be treated as a partnership for Federal income tax
2. French Banks created and funded 2 French entities (“the SAS”) with $930M. In
exchange for the $930M, SAS issued $475M in 1% Convertible Notes and
$455M in Class A Shares to the French Banks.
3. Pritired transferred the entire $300M to the SAS. In exchange, the SAS issued
$9M of Class B shares and $291 of Perpetual Certificates to Pritiered.
 When added to the $930M from the French Banks, SAS had $1.23B. Thus,
the transaction essentially provided $300M of new funds to the French
Notice of Final Partnership Administrative Adjustment (FPAA)
 The IRS alleged the transaction was an abusive arrangement and its
FTCs were disallowed for 5 reasons:
1. The B shares and PCs were considered to be debt instruments and
not equity
2. The transaction was a loan because Pritiered was not a partner in the
3. Pursuant to the anti-abuse rule in section 1.701-2, the transaction was
re-characterized as a loan because the B shares and PCs were debt
4. The special allocation of FTCs to Pritiered lacks economic effect
5. The transaction generating the FTCs lacks economic substance
District Court’s Analysis of the FPAA
#1 Whether the transaction should be characterized as a loan
 The court found the Class B Shares and PCs had attributes more
closely related to debt and that the substance of the transaction was a
 The court’s debt/equity analysis focused on characterization, market risk,
credit risk, and, voting rights.
#2 Whether the transaction lacks economic substance
 Applying the 8th Circuit’s conjunctive economic substance test, the
court determined that taxpayer had no realistic opportunity to earn a
profit independent of the FTCs, and did not expect to earn a meaningful
return without the foreign tax credits.
 The court rejected taxpayer’s argument that it should be permitted to
rely on examples in Notice 98-5, which considered as a factor in
determining whether an arrangement was abusive the expected
economic profit from the arrangement when compared to the FTCs
District Court’s Analysis of the FPAA
#3 Whether the transaction violates the anti-abuse rule under of section
 The court held that the transaction did not have a substantial
business purpose because it was "designed to transfer and shift
the payment of French taxes to instruments that otherwise have
a low and undesirable return."
#4 Whether the transaction lacks substantial economic effect pursuant to
section 1.704-1(b)(2)
 The court held that even if the transaction constituted a bona
fide partnership, the special allocation of French tax expense
and net income lacked substantial economic effect and was not
consistent with the partners’ interests in the partnership.
Samueli v. Commissioner
Background — Black Letter Law Observations:
 If I own a bond with OID, I accrue interest income.
 If I lend a security to another party (e.g., for that person to sell in a
“short sale”),
I am no longer the tax owner of the security (although I am in the
same economic position).
 If I lend a security in a transaction that qualifies under section 1058,
my original basis in the security will carry over onto the security
that is ultimately returned to me. Furthermore, my holding period in
the security is not interrupted.
The Basic Economic Transaction:
Cash-basis taxpayer (Samueli) buys fixed-yield zero coupon bond, with purchase
price principally financed through floating rate debt. This is a bet that short-term
rates will go down.
 Taxpayer would be required to accrue OID, but gets deductions for
interest only when paid.
The Actual Transaction (simplified):
1. Taxpayer buys zero coupon bond for $80, financed with LIBOR-rate margin loan.
2. Taxpayer lends bond back to broker, in exchange for cash collateral. Securities loan is
unusually long-term (450 days) and is scheduled to terminate shortly before bond
 Taxpayer repays the margin loan with the cash (so cash is “circling”).
 Taxpayer pays LIBOR on the cash collateral (so no change to funding costs).
 As an economic matter, the bond will accrete in value over the term of the securities
loan. Taxpayer takes position he is not required to accrue OID because he no
longer owns the bond.
3. At maturity of stock loan, broker is obligated to return the bond to taxpayer. But
instead, broker buys the bond, for $97.
Samueli — The Opposing Positions
TP position #1:
 TP has $17 of LTCG (from the purchase of the bond at $80 and disposition at
 Section 1058 operates to ensure taxpayer takes a carryover basis of $80 in bond
when it is returned.
 Section 1058 also allows TP’s holding period to continue un-interrupted.
 TP also has $16 of ordinary deduction (from the delayed payment of the fee for
the collateral)
IRS Counterargument:
 TP purchased bond on day 1 and immediately sold it to the bank on the same
 In other words, TP did not lend the bond to the bank in a non-recognition transaction
governed by section 1058. On day 1, TP has basis of $80, and sold the bond for
the bank’s obligation worth $80 — realization and recognition event, but no gain/loss
simply as a result of the values.
 Instead, TP has entered into forward contract to buy bond at maturity (end of
year 1.75). Ultimately, TP buys bond at $96 on that date and sells it for $97 that
same day — resulting in $1 of Short-term CG.
TP position #2:
 Even if the day 1 transaction is not a securities loan, the resulting forward
contract was held for more than a year. It was cash-settled. Therefore, the $1
of profit is Long-term CG.
Samueli – The Tax Issues
#1. Was the day 1 transaction, in fact, a valid securities loan under section
 In order for arrangement to qualify for non-recognition, the transferor
must be in the same economic position.
 The agreement by which the securities are lent must “not reduce the . . .
opportunity for gain of the transferor of the securities in the securities
transferred.” Section 1058(b)(3).
 TP could not call back the securities for 1.75 years. 9th Circuit Court
 “During this period, TP could not have taken advantage of a short-lived
spike in the market value of the securities . . . Common sense compels the
conclusion that this reduced the opportunity for gain that a normal owner of
the securities would have enjoyed.”
 “our conclusion that the transaction . . . reduced TP’s opportunity for gain
does not necessarily imply a conclusion that a securities loan must be
terminable upon demand to satisfy the requirement of section 1058(b)(3).”
 What of shorter “term loans” of securities? 180, 90, 60 days? Note:
court’s emphasis on purpose of section 1058, and that it is exclusive
avenue for non-recognition.
Samueli – The Tax Issues
#2. Assuming a sale occurs on day 1 (not section 1058 transaction), does the
cash settlement of the arrangement generate long term capital gain?
IRS argues that cash-settlement of the contract at maturity does not reflect a
cancellation or termination of the contract under section 1234A. Instead, it merely
reflects the fulfillment of the contract. If securities had actually been delivered, TP
would have been purchased for $96 and sold at $97 (with short-term holding
period). It is not appropriate to “mark-to-market” the forward contract (and recognize
a $1 LTCG) — rather, the contract must be treated as having been
*9th Circuit Court agrees.
Note: The IRS & court position is directly contrary to analysis in CCA 201104031
(re: closing forward with borrowed shares)
Viva Hammer
KPMG LLP -- Washington National Tax
[email protected]
(202) 412-9798
Edward Kleinbard
USC Law School
[email protected]
(213) 740-4582
Stephen Larson
Internal Revenue Service -- Financial Instruments and Products
[email protected]
(202) 622-3900
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