Taxation of Financial Products and
Transactions
Practicing Law Institute -- Tax
Policy
Lessons From the Crash
Andrew Needham
Matthew Stevens
Michael Novey
Viva Hammer
January 26, 2011
Disclaimer
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT
INTENDED OR WRITTEN TO BE USED, AND
CANNOT BE USED, BY A CLIENT OR ANY OTHER
PERSON OR ENTITY FOR THE PURPOSE OF (i)
AVOIDING PENALTIES THAT MAY BE IMPOSED ON
ANY TAXPAYER OR (ii) PROMOTING, MARKETING
OR RECOMMENDING TO ANOTHER PARTY ANY
MATTERS ADDRESSED HEREIN.
Accrual of OID on Distressed Debt
X, an accrual method taxpayer, buys a $1000 distressed
bond for $200. On the date of original issue, the bond had
an issue price of $1000 and a 10% coupon. At the time of
purchase, X did not expect to collect more than $1000 on
the bond
Must X continue to include the 10% interest as it accrues?
No: an accrual method taxpayer has no obligation to report
stated interest of “doubtful collectibility”
But what if the bond paid interest at the same rate, but
either “in-kind” or at maturity?
In TAM 9538007, the IRS concluded that the doubtful collectibility
doctrine does not apply to OID
Was it right?
What about the $800 of market discount?
3
Accrual of Market Discount on Distressed
Debt
Market discount is defined as the excess of the face
amount of a debt instrument over the taxpayer’s
basis in the debt
Under the statute, therefore, X acquired the bond at a
“market discount” of $800
Assume that X ultimately collects $400 on the bond,
realizing a $200 gain
X must therefore report the $200 gain as ordinary
income, but only to the extent of the accrued “market
discount”
So what portion of the $200 gain represents
“accrued” market discount?
Is any of it market discount?
4
Do the Market Discount Rules Even Apply
to Distressed Debt?
No guidance from the IRS or Treasury. Must X
continue to include the 10% interest as it accrues?
The 2010-2011 Priority Guidance Plan released in
December by Treasury and the IRS includes “guidance
relating to accruals of interest (including discount) on
distressed debt”
Until then, we are left with …
Common Law – “Doubtful collectibility” doctrine
TAM 9538007
Legislative History
What about common sense?
5
The Economics of Debt Prices:
Interest Rates

Bond prices are sensitive to interest rates:
When interest rates go up…
%
$
…Bond prices go down
• This is because the bond now pays interest at a “below
market” rate, causing the price of the bond to fall.
 Similarly…
%
When interest rates go down…
…Bond prices go up
$
 This is because the bond now pays interest at an “above
market” rate, causing the price of the bond to rise
6
The Economics of Debt Prices: Financial
Distress
But suppose that the discount arises not from an
increase in interest rates, but from a (severe) decline
in credit quality?
What happens to the price of a bond under these
conditions?
Does it depend upon the bond’s maturity date?
Does it depend upon the bond’s seniority within the
capital structure?
Let’s look at some empirical data
7
The Lehman Brothers Debacle in 2008
Lehman Brothers bonds of every maturity converged to the same
price, culminating in the largest bankruptcy in U.S. history
Lehman Brothers Bond Prices Leading Up to September 15, 2008 Bankruptcy
120
100
Price($)
80
Bonds of
Different
Maturities:
2010 Bond
2017 Bond
2038 Bond
60
40
20
0
5/15/2008
5/29/2008
6/12/2008
6/26/2008
7/10/2008
7/24/2008
8/7/2008
8/21/2008
9/4/2008
Period Preceding Bankruptcy Filing
8
The Enron Debacle in 2001
Enron bonds of every maturity converged to the same price,
culminating in one of the largest bankruptcies in U.S. history
Enron Bond Prices Leading Up to December 3, 2001 Bankruptcy
120
Price ($)
100
Bonds of
Different
Maturities:
80
60
40
20
2003 Bond 0
2005 Bond 7/31/01
2028 Bond
8/14/01
8/28/01
9/11/01
9/25/01
10/9/01
10/23/01
11/6/01
11/20/01
BANKRUPT
9
The WorldCom Debacle in 2002
WorldCom bonds of every maturity converged to within one
dollar, culminating in the next biggest bankruptcy in U.S. history
WorldCom Bond Prices Leading Up to July 15, 2002 Bankruptcy
120
100
Price ($)
80
60
40
Bonds of
Different
Maturities:
2003 Bond
2005 Bond
2031 Bond
20
0
1/31/02 2/14/02 2/28/02 3/14/02 3/28/02 4/11/02 4/25/02
5/9/02
Period Preceding Bankruptcy Filing
5/23/02
6/6/02
6/20/02
7/4/02
BANKRUPT
10
The Distress Anomaly
The 2 Year Bond
The 20 Year
Bond
$1000
$1000
Subordinated
Subordinated
4%
7%
“Revised” Issue Price
$500
$500
Nominal Yield
79%
16%
Ultimate Settlement Amount
$700
$700
Total Gain
$200
$200
$200
$8
$0
$192
Issue Price
Rank
Coupon
 Interest component
 Capital gain component
11
II. Cancellation of Indebtedness and
AHYDO
Problem
Debt market disrupted
Market deteriorated suddenly. Trouble began in 2007, spiked
in late 2008
Thin trading
Low market prices
Spreads widened
Government borrowing rates plummeted.
Corporate borrowing rates skyrocketed, especially for issuers
with lower credit ratings.
TED Spread (3-mo. LIBOR to T-bill)
» Hovered around 40 bp 2005-2006
» Peaked at over 460 bp in October 2008
12
II. Cancellation of Indebtedness and
AHYDO
Problem (cont’d)
Mark-to-market rules failing in many contexts.
In tax context Certain debt instruments valued according to market value
where possible
Valuation rules define market value broadly.
Leads to inappropriate triggering of:
Recognition of income under the cancellation of indebtedness
(COD) rules; and
Disallowance of OID deductions under rules for certain high-yield
debt obligations (the AHYDO rules)
13
II. Cancellation of Indebtedness and
AHYDO
Problem (cont’d)
Virtually all bond trading done over-the-counter in privately
negotiated transactions
Prices traditionally not publicly reported
Market less liquid than equity market
About 80% of bonds did not trade in a typical month even before
credit crisis
Only 5% of outstanding par value traded in typical transaction.
(Hotchkiss and Jostova, Determinants of Corporate Bond Trading:
A Comprehensive Analysis, Working Paper, June 21, 2007)
Most held by large institutions – about 40% of corporate bonds held
by life insurance companies
(Hotchkiss and Jostova, citing Hong and Warga, An Empirical
Study of Corporate Bond Market Transactions, Financial Analysts
Journal, 56, 32-46 (2000))
14
II. Cancellation of Indebtedness
Income and AHYDO
Hypothetical
Facts
Borrower issues debt instrument for $100 million at 6% coupon, 7 yr
term
Borrower amends terms of debt after 6 months
Trades 50 bp increase in interest rate for adjustments in covenants.
Term and principal amount unchanged
Minimum trading
Current “bid” quotes for debt instrument listed on an electronic
secondary market at 50 cents/dollar at time of amendment
Little or no actual recent trading
Tax treatment (pre and post Stimulus Act)
Amendment is a “significant modification”
Original debt instrument deemed exchanged for a new debt instrument.
Borrower must recognize $50 million of COD income
$50 million of offsetting OID deductions on new debt instrument are
disallowed to issuer under AHYDO rules
15
II. Cancellation of Indebtedness and
AHYDO
Law: Issue Price
Issue price is how the tax law values a debt
Debt instruments issued for cash: Issue price is first price at
which a substantial amount of the debt is sold for money
IP of original debt instrument = $100 million
See Regulations § 1.1273-2(a)
Debt instruments issued for property: Law looks for market
price if either the new or old debt instruments are “publicly
traded”
IP of new debt instrument = $50 million
See Regulations § 1.1273-2(b)
Law provides different valuation mechanism under IRC
Section 1274 if there is no public trading and certain other
conditions apply
16
II. Cancellation of Indebtedness and
AHYDO
Law: Issue Price (cont’d)
“Publicly Traded Property” is defined broadly. See
Regulations § 1.1273-2(b)
Exchange listed, e.g., listed on a national securities exchange
Market traded, e.g., traded on an interbank market
Appears on a quotation medium
Includes a computer listing disseminated to subscribing brokers, dealers,
or traders containing recent price quotes, e.g., Market
Craig’s List for debt instruments?
Readily quotable, i.e., price quotes readily available from dealers,
brokers or traders
17
II. Cancellation of Indebtedness and
AHYDO
Law: Issue Price (cont’d)
Proposed regulations defining “Publicly Traded Property” were
issued on January 6, 2011 under Regulations § 1.1273-2(f)
Exchange listed, e.g., listed on a national securities exchange
Sales price of an executed purchase or sale is reasonably
available
Firm quotes
Price quote is available from at least one broker, dealer or pricing
service
Quoted price is substantially the same as the price at which it
could be sold
The identity of the party providing the quote must be reasonably
ascertainable
Indicative Quotes
Price quote is available from at least one broker, dealer or pricing
service and the quote is not a firm quote
18
II. Cancellation of Indebtedness and
AHYDO
Law: Issue Price (cont’d)
New de-minimis trading rule:
Each trade during the relevant 31 day period is for amounts less
than $1 million and the aggregate amount of such trades does
not exceed $5 million
Small debt issue exception:
Property is not treated as traded on an established market if the
original stated principal amount of the issue does not exceed
$50 million
19
II. Cancellation of Indebtedness Income
and AHYDO
Law: Debt Modifications. See Regulations § 1.1001-3(b) and
(e)
Significant modification of a debt instrument is treated as an
exchange of the original debt instrument for a new debt
instrument.
Low threshold for “significant” modification
Does not distinguish between an increase or decrease in the
borrower’s burden
Examples (non-exclusive list):
Change in interest rate (up or down); and
Change in principal amount (up or down)
Is it debt?
Final regulations issued under section 1.1001-3(f) in 2011 addressing when a
taxpayer’s financial deterioration should be considered to determine whether
a modification results in something that is not debt for tax purposes. T.D.
9513
20
II. Cancellation of Indebtedness and
AHYDO
Deemed Exchange
If a debtor satisfies a debt obligation by issuing a new
debt instrument, then treated as satisfying the old debt
with a payment equal to the issue price of the new debt.
See IRC Section 108(e)(10)
COD Income
Issuer recognizes COD income upon repurchase of a
debt instrument for an amount less than its adjusted
issue price. See Regulations § 1.61-12(c)(2)(ii)
21
II. Cancellation of Indebtedness and
AHYDO
Example: COD
Facts
$100 million debt
Covenants are modified in return for 50 bp increase in interest rate
Modified debt trades at 50% of face on thin secondary market
Issue Price
Old debt: $100 million, measured by cash proceeds
New debt: $50 million, measured by market quote
COD: IP of old debt minus IP of new debt = $50
million
Result: Debtor is taxed as if it received $50 million of
income, even though its obligation under the debt
instrument was increased in the transaction.
22
II. Cancellation of Indebtedness and
AHYDO
Law: AHYDO. See IRC Sections 163(i) and (e)(5)
AHYDO Definition
Term greater than 5 years
Yield greater than AFR + 5%
“Significant OID”
AHYDO Rules
Portion of OID disallowed as a deduction to the issuer.
Disallowed portion can easily reach 100% of total OID because based on
AFR plus 6%
COD inclusion not reduced due to disallowed deductions for OID created
by same transaction
Remaining OID only deductible when paid
Increases timing mis-match between the COD and OID created by
the same transaction
23
II. Cancellation of Indebtedness and
AHYDO
Example: AHYDO Definition
Facts
Borrower issues debt instrument for $100 million at 6% coupon,
7 yr term
Borrower amends terms of debt after 6 months
Trades 50 bp increase in interest rate for adjustments in
covenants.
Term and principal amount unchanged
Minimum trading
Current “bid” quotes for debt instrument listed on an
electronic secondary market at 50 cents/dollar at time of
amendment
Little or no actual recent trading
24
II. Cancellation of Indebtedness and
AHYDO
Example: AHYDO Definition (cont’d)
New debt instrument is an AHYDO
Term of 6.5 years is greater than 5 years
Yield of 21% is greater than AFR plus 5%
Yield calculated from new issue price
Current AFR is 1.92%, so bar is now at 6.92%.
Significant OID
OID = SRPM minus IP = $50 million
Test in IRC Section 163(i)(2), in essence, compares the OID
accrued after 5 years to the IP x Yield to determine whether OID
is “significant”
Note on Issue Price - Both the high yield and high OID are a direct
result of the low market-based issue price
25
II. Cancellation of Indebtedness and
AHYDO
Example: AHYDO Definition (cont’d)
Disqualified portion. See IRC Section 163(e)(5)(C)
Total return x (disqualified yield / yield)
Total return is OID plus Qualified Stated Interest (QSI)
Disqualified yield = yield minus (AFR + 6%)
Capped at total amount of OID
Example
OID = $50 million. Total Return ($92 million) minus QSI
($42 million)
Yield = 21%, disqualified yield = 13%
Disqualified portion = $92 million x (13/21) = $57 million,
but capped at $50 million (total OID)
26
II. Cancellation of Indebtedness and
AHYDO
Example: AHYDO Definition (cont’d)
Result:
Debtor realizes $50M in COD income;
Debtor allowed $0 offsetting OID deductions; and
Debtor owes same principal amount, over same term, at a
higher interest rate
Reason: Issue price re-set to value of low market
quote because of the debt modification
27
II. Cancellation of Indebtedness and
AHYDO
Interaction of Rules
COD normally offset by OID deductions
COD = IP(old) minus IP(new) = $50 million
OID = SRPM minus IP(new) = $50 million
Imperfect offset because of timing difference
This offset disrupted by the AHYDO rules
Disallows some or all of the OID deductions that correspond
to the COD inclusion
Any remaining OID deductions deferred
Remainder deductible when paid (instead of when accrued)
Worsens original timing difference between COD inclusion and
OID deductions
28
II. Cancellation of Indebtedness and
AHYDO
Interaction of Rules (cont’d)
Are results unintended?
COD meant to tax economic gain from being relieved of a debt.
AHYDO meant to reclassify excess OID on certain equity-like
securities as dividends
Real-world consequences
COD creating large, unexpected income inclusions.
Can create immediate cash tax liability if issuer does not have
enough NOLs to offset the COD income
Even issuers in serious financial trouble today have not necessarily
built up sufficient NOLs to offset a sudden COD income inclusion
from a debt modification
29
II. Cancellation of Indebtedness and
AHYDO
American Recovery & Reinvestment Act of 2009
(Stimulus Act)
Election to defer recognition of COD, effective for transactions
in 2009 and 2010 only. Does not apply to transactions
occurring in 2011
Recognize COD over 5-year period, beginning in 2014.
Must also defer corresponding OID deductions to match COD
inclusions with OID deductions
Applies to COD from debt reacquisitions.
By issuer or related person
For cash, new debt, or corporate stock or partnership interest if debt
contributed to capital
Includes debt modifications
Includes complete forgiveness of debt by holder.
Available for Debt issued by a C corporation (or other person if connected with a
trade or business of that person)
Debt issued in 2009 or 2010
30
II. Cancellation of Indebtedness and
AHYDO
American Recovery & Reinvestment Act of 2009 (Stimulus Act)
(cont’d)
AHYDO rules suspended for New debt issued in exchange for old debt
In debt-for-debt exchange (or modification)
Old debt not an AHYDO
After August 31, 2008 or in 2009
»
Notice 2010-11 extended the AHYDO suspension for new debt
issued during 2010. No extension for 2011 so far.
No change in obligor, no contingent portfolio interest, no debts issued to
related persons
Subsequent exchanges with same effective dates.
Treasury granted authority to Extend suspension of AHYDO rules into the future
Temporarily substitute a higher rate for the AFR in the definition of AHYDO
after 2009
Both permitted if conditions in the debt capital markets continue to be
distressed
31
II. Cancellation of Indebtedness and
AHYDO
Open Questions on the Proposed Regulations
Defining “Publicly Traded”
The de minimis trading exception refers to “trades,” does this
mean that only actual trades are taken into account? In the
context of a debt modification, is the deemed acquisition a
“trade” for these purposes?
The FMV of a debt instrument is presumed to be equal to its
traded price, sales price or quoted price. If more than one
traded price, sales price or quoted price is available, a taxpayer
may use any reasonable method, consistently applied, to
determine the price
Is this presumption irrebutable for debt instruments for which only
one price is available?
How does this rule compare with the special rule for property for
which there is only an indicative quote?
32
II. Cancellation of Indebtedness and
AHYDO
Summary
Debt modifications trigger COD and AHYDO rules
Tax rules value debt according to market value where possible
Market values plummeted suddenly due to disruption in credit
markets
Debtors surprised by tax effects
Temporary relief available for transactions occurring
in 2009 or 2010
Will this temporary relief be extended for 2011?
Opportunity to craft permanent fixes
33
International Aspects of Financial
Transactions
Broaden portfolio interest deduction
Expansion of section 956
34
Expansion of portfolio interest exemption
from withholding tax
Current limitations are substantial:
Must be unrelated parties (even a 10% shareholder
cannot receive interest free of U.S. withholding tax)
Must not be “received by a bank on an extension of
credit made pursuant to a loan agreement entered into
in the ordinary course of its trade or business”
Must not be subject to certain contingencies
35
Expansion of portfolio interest exemption
from withholding tax
Does the limitation to unrelated parties make sense
(e.g., why not let a non-U.S. person hold convertible
debt)?
Even if it generally makes sense, should it be relaxed
(e.g., to more than 50% share ownership)?
36
Expansion of portfolio interest exemption
from withholding tax
What about the exclusion for banks?
More a regulatory concern than a tax concern
Was this ever justified?
Does it make sense to force the banks to originate the
loans, and then sell them to hedge funds?
37
Expansion of portfolio interest exemption
from withholding tax
How about contingent interest?
This one probably makes more sense, because
justified in terms of avoiding quasi-dividend payments,
unless . . . .
Congress adopts a “portfolio dividend” provision
38
Expansion of portfolio interest
exemption from withholding tax
What about a portfolio dividend provision (at least for
dividends paid on certain types of equity)?
Only preferred stock?
Also common stock?
Should a portfolio dividend provision replace the
portfolio interest exemption?
39

Pledge of CFC Stock
Lender
$1000

Multiple Inclusions Exceed
Borrowing
Lender
U.S.
Borrower
“Deemed
Dividend”
of $1000
$1000
U.S.
Borrower
““Deemed
Dividend”
of $1000
“Deemed
Dividend”
of $1000
Stock Pledge
CFC
CFC
CFC
(E&P = $1000)
(E&P = $1000)
GUARANTEE
GUARANTEE
(E&P = $1000)

Lender
Loan Exceeds FMV of CFC
$1000
U.S. Borrower
“Deemed Dividend”
of $1000
Guarantee

Loan Exceeds FMV of Pledged Asset
$1000
Lender
U.S. Borrower
“Deemed Dividend”
of $1000
CFC
CFC
(E&P = $1000)
Assets
FMV = $500
E&P = $1000
Pledge
of
$100 Asset
Assets
FMV = $100
Assets
FMV = $2000
40
Derivatives
Major issues
Credit derivatives
Dodd-Frank
Secondary issues
41
Derivatives
Credit Default Swaps
TRS and other credit derivatives all converged in
CDS
Need for regulating CDS
Self regulation – big bang
Federal govt. regulation – Dodd-Frank
Tax treatment
Never settled prior to Dodd-Frank, several approaches
Post Dodd-Frank with clearinghouses and standardization
42
Derivatives
CDS Clearinghouse Operations
Clearinghouse Corporation/Intercontinental Exchange
Clearinghouse
Regulated by New York banking department and Federal
Reserve
Trades negotiated OTC, then submitted to clearinghouse
Clearinghouse becomes sole counterparty; daily netting occurs.
Index contracts only initially
Participants currently limited to banks and broker-dealers.
Chicago Mercantile Exchange/Citadel Exchange and
Clearinghouse
Trades entered into on exchange
Otherwise expected to function similarly
European Clearinghouse
Liffe/LCH-Clearnet Clearinghouse (launched December 2008).
NYSE Euronext/Eurex Clearinghouse
43
Derivatives
Tax Issues
Clearinghouse is not an exchange
Effect on insurance/guarantee vs. derivative issue
Effect on pending timing rules?
Is clearinghouse an exchange for purposes of
section 1256?
Possible mismatch in character and timing with hedges (mixed
straddles)
Competitive (dis)advantage vs. non-exchange CDSs?
What happens if CDS is cleared in mid-life?
Last page of Dodd-Frank and effect on swaps not
mentioned there
44
Derivatives
Secondary issues
Mark to market for a broader class of instruments
Accrual of income on prepaid forwards
Nonrecognition of gain or loss on securities loans
45