This is MoFo. 2 Agenda Introduction AmbacTax Treatment of Credit Default Swaps Notice – Wash Sales/Money Market Fund Shares FATCA Update Debt vs. Equity Trust Preferred Securities Contingent Convertible Bonds Caselaw Developments U.S. View Excess Mortgage Servicing REIT Basket Option Contracts Tax Reform? Structured Notes
This is MoFo. 3 Current U.S. Tax Rates Marginal Rates For Unmarried Individuals with Taxable Income For Married Individuals Filing Jointly with Taxable Income Over $400,000Over $450, % Maximum Dividend and Capital Gain Rates For Unmarried Individuals with Taxable Income For Married Individuals Filing Jointly with Taxable Income Up to $400,000Up to $450,00015% Over $400,000Over $450,00020% Medicare Tax on Net Investment Income For Unmarried Individuals with Modified Adjusted Gross Income For Married Individuals Filing Jointly with Modified Adjusted Gross Income Over $200,000Over $250,0003.8% Maximum Combined Tax Rates on Interest and Dividends Interest39.60% % = 43.40% Dividends20% % = 23.80%
This is MoFo. 4 Ambac CDS AMBACs subsidiary (AMBAC Assurance Corporation) was in the financial guarantee insurance business AAC wrote credit default swaps (CDS) on asset/mortgage backed securities, many of which were rated AAA AAC received periodic payments from third parties and agreed to pay the loss, if any, upon a default When the financial crisis hit, the AMBAC consolidated group claimed over $4 billion in ordinary losses relating to its CDS and carried the loss back for a $700 million IRS tax refund AMBACs parent filed for federal bankruptcy protection in November, 2010, largely because of fear the IRS would try to clawback the refund
This is MoFo. 5 Ambac CDS Tax issue: Whether losses on CDS were capital or ordinary and whether they were currently deductible (AMBACs position) or deductible only when paid (IRS position)? IRS Notice : IRS seeks further information on CDS Prop. Reg. section (c)(1)(iii) [September 16, 2011]: CDS are notional principal contracts entitled to ordinary income and loss treatment
This is MoFo. 6 Settlement (Announced April 9, 2013) AMBAC will pay the Government $101.9 million. AMBAC liable for possible future additional payments of up to $14.9 million. AMBAC will reduce its net operating loss carryovers attributable to the CDS contracts at issue by $1 billion. Manhattan U.S. Attorney Preet Bharara: The proposed settlement reflects an extensive investigation into Ambacs reported financial losses and accounting methods in the wake of the financial crisis, and, if approved, will result in a significant recovery of Treasury funds. The settlement will also prevent Ambac from taking $1 billion in future offsets against its income and thus potentially reducing its tax burden by several hundred million dollars, a reduction to which it is not entitled.
This is MoFo. 7 Notice Wash Sales/Money Market Fund Shares Issue: SEC proposal that certain money market funds will not maintain a $1 per share net asset value This raises the prospect that a shareholder could redeem shares at a loss, then reinvest within the 30 day wash sale period and have the loss deferred under IRC § 1091 Notice : 0.5% de minimis standard where IRS will not disallow loss under wash sale rules
This is MoFo. 8 FATCA Update Foreign Account Tax Compliance Act (2010)Designed to Find Undisclosed Foreign Bank Accounts Held by U.S. Taxpayers New IRC Section 1471: A Withholding Agent Must Withhold 30% on All Withholdable Payments Made to a Foreign Financial Institution Unless the FFI Signs an Agreement with the IRS to Information Report on its U.S. Account Holders A Withholdable Payment is: Any U.S.-source payment of interest, dividends and other fixed or determinable annual or periodical gains, profits, and income (FDAP); for example bond interest or stock dividends Gross proceeds from sale of property that is of a type that can produce U.S.- source dividends or interest, for example gross proceeds on the sale of stocks or bonds
This is MoFo. 9 FATCA: Key Dates FATCA Withholding Dates Withholdable Payments:Withholding begins on: Any payment of U.S. source FDAP income, such as U.S. source interest (including OID) and dividends July 1, 2014 Gross proceeds from the disposition of property producing FDAP-type income January 1, 2017 Foreign passthru paymentsJanuary 1, 2017 Grandfathered Obligations:Obligation must be outstanding on: All ObligationsJuly 1, 2014
This is MoFo. 10 Debt vs. Equity is Still With Us… Trust Preferred Securities Contingent Convertible Bonds Caselaw Developments U.S. View
This is MoFo. 11 Trust Preferred Securities Trust preferred securities are in the process of being phased out as Tier 1 regulatory capital as a result of Dodd-Frank and Basel III. As a result, most trust preferreds are being called or refinanced. The refinancing, however, has occurred at a much slower pace. In 2012, $46.6 billion of trust preferreds were called, but only $21.3 billion of new preferred stock was issued.
This is MoFo. 12 Contingent Convertible Bonds Barclays Bank PLC as issuer. $3 billion CoCo (November 2012) % ten year notes, holder must transfer for nil value to parent if Barclays CET1 declines below 7%. $1 billion CoCo (April 2013). 7.75% ten year notes (callable after five years), holder must transfer for nil value to parent if Barclays CET1 declines below 7%. Tax issues – debt or equity? Unconditional promise to pay a sum certain? Treatment in the UKtax deductible under current law. Treatment of U.S. holdersequity eligible for preferential qualified dividend income treatment.
This is MoFo. 13 Caselaw Developments Recent debt v. equity caselaw PepsiCo Puerto Rico (TC Memo ). Held: Equity – taxpayer wins. NAGP (ScottishPower) (TC Memo ). Held: Debt – taxpayer wins. Hewlett-Packard (TC Memo ). Held: Debt – taxpayer loses factors Citing Hardman v. United States, 827 F.2d 1409 (9th Cir. 1987) (11 factors); Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972) (13 factors); A.R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970) (11 factors); Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980) (13 factors), etc. Find out what the law is in your Circuit!
This is MoFo. 14 U.S. View Orderly Liquidation AuthorityDodd Frank grants extraordinary powers to FDIC. Financial institution creditors subject to bail-in of their debt. So in the U.S., rather than replace trust preferred with a new tax deductible instrument (like CoCos), the plan is to make debt more equity-like.
This is MoFo. 15 Excess Mortgage Servicing REIT Mortgage Servicing Fee = reasonable fee + Excess Servicing Spread Excess Servicing Spread treated as a coupon strip under Section REIT Requirements: At least 75% of a REITs assets must be real estate assets At least 75% of a REITs gross income must be qualifying income. Includes interest on obligations secured by mortgages on real property or interests in real property
This is MoFo. 16 Excess Mortgage Servicing REIT Questions: Is the Excess Servicing Spread a real estate asset? Is income from the Excess Servicing Spread qualifying income? PLRs & : Yes. Excess servicing spread is a real estate asset and generates qualifying REIT income.
This is MoFo. 17 Basket Option Contracts Bank buys portfolio of stocks desired by Fund Fund buys a two-year option whose value is tied to the portfolio. Fund controls the contents of the portfolio. Despite constant turnover in portfolio, Fund continues to hold only one asset, the option.
This is MoFo. 18 Basket Option Contracts Desired result: Long-term capital gain rather than short-term trading gain IRS Memorandum AM : Fund owns the portfolio, must recognize gain and loss from trades in the portfolio Particularly aggressive transaction Bloomberg article: Simons Strategy to Shield Profit From Taxes Draws IRS Ire, July 1, 2013
This is MoFo. 19 Tax Reform? Current System for Taxing Derivatives House Ways & Means Committee Discussion Draft Mark-to-Market for Derivatives Accrual of Market Discount COD on Debt Exchanges Average Basis Hearings Held on March 20, 2013
This is MoFo. 20 Current System for Taxing Derivatives InstrumentCategorization for Federal Income Tax Purposes Governing Provision / Law Tax Treatment Options"1256 Contracts (e.g. S&P 500 options) IRC Section % long-term capital gain/loss; 40% short-term capital gain/loss Non-1256 Contracts(e.g. options on a narrow-based stock index) "Open- Transaction" Wait-and-see approach; Capital gain/loss Futures"1256 Contracts (e.g. Oil Futures) IRC Section % long-term capital gain/loss; 40% short-term capital gain/loss Securities Futures Securities futures (e.g. futures on Google stock on OneChicago) IRC Section 1234B Wait-and-see approach; Capital gain/loss SwapsCarved out from Section 1256 by Dodd-Frank (e.g. Oil Swaps) Regulations Current accrual; Capital gain/loss; Contingent payments? Current tax treatment of certain financial instruments traded on the various exchanges:
This is MoFo. 21 Mark-to-Market for Derivatives Academics have been calling for a mark-to-market system for the taxation of financial instruments for a long time. Joint Senate Finance – House Ways & Means Committee hearing on December 6, JCT Report identifies the five financial instruments: Stock Debt Options Forwards Notional Principal Contracts
This is MoFo. 22 Chairman Dave Camp (R-MI) of the House Ways & Means Committee proposed a mark-to-market system for the taxation of derivatives on January 24, Press Release: The lack of consistent and comprehensive tax policy has also contributed to some corporate scandals and the recent financial crisis that devastated our economy and threatened our standing in the global community. Updating these tax rules to reflect modern developments in financial products will make the code simpler, fairer and more transparent for taxpayers; and it will also help to minimize the potential for abuse that has occurred in the past. Subcommittee Hearing: March 20, 2013 Mark-to-Market for Derivatives
This is MoFo. 23 New Code Sections IRC Section 485 – Treatment of derivatives. IRC Section 486 – Derivatives defined. Applies to all derivatives held by dealers (who are currently subject to IRC Section 475 with respect to derivatives held as inventory or for sale). Mark-to-Market for Derivatives
This is MoFo. 24 Obsolete Code Sections IRC Section 1234B – Gain or loss on a securities futures contract treated as gain or loss from the sale or exchange of property that has the same character as the underlying property in the hands of the taxpayer. IRC Section 1236 – Capital gains treatment for securities that are held by dealers for personal investment. IRC Section 1256 – 60/40 treatment (60% long-term capital gain and 40% short- term capital gain) for certain futures and options contracts. Mark-to-Market for Derivatives
This is MoFo. 25 Mark-to-Market for Derivatives Basic Rule Mark-to-market – any derivative held at the close of a taxable year is treated as sold for its fair market value on the last business day of such year, and gain or loss would be recognized in such year. Basis – ongoing adjustments for gain or loss recognized. Items of Income, Gain, Loss, and Deduction Treated as ordinary income or loss. Treated as attributable to a trade or business for purposes of IRC Section 172(d)(4), which limits the non-trade or business deductions of non-corporate taxpayers to non-trade or business income.
This is MoFo. 26 Mark-to-Market for Derivatives Derivative definition would be broad: Any evidence of an interest in (or any derivative financial instrument with respect to) stock, partnership interest, beneficial ownership interest in a trust, debt, real property (with certain exceptions), actively traded commodity, currency, and notional principal contract. Includes any derivative financial instrument with respect to any of the above. Derivative Financial Instrument: any option, forward contract, futures contract, short position, swap, or similar financial instrument. Includes any embedded derivative component in a debt instrument. Embedded Derivative Component: any term of a debt instrument that affects its cash flow or the value of other payments required by the instrument in a way similar to a derivative. Does not include stock, straight debt, CPDI or VRDI. As written would include compensatory options and options on partnership interests.
This is MoFo. 27 Mark-to-Market for Derivatives Special Provisions Mixed Straddles – mark-to-market regime applies to all non-derivative positions that are part of a tax straddle with a derivative. Terminations / Transfers – mark-to-market regime applies to any termination or transfer of the rights or obligations with respect to a derivative during the taxable year, whether by exercise, settlement, etc. Fair Market Value If not readily ascertainable, look to method used in report or statement (i) to shareholders, partners or other persons provided in the applicable Treasury Regulations, or (ii) for credit purposes. Fair market value of an embedded derivative component in a instrument is (i) the fair market value of the instrument with the component over (ii) the fair market value of the instrument without the component.
This is MoFo. 28 Mark-to-Market for Derivatives Unanswered Questions Who will be covered? Existing derivatives - grandfathered? Opportunity to opt-in to the regime? What will be covered? Mutual funds? Coordination with IRC Section 1032 IRC Section 1032:... No gain or loss shall be recognized by a corporation with respect to any lapse or acquisition of an option... to buy or sell its stock (including treasury stock).
This is MoFo. 29 Structured Notes 2012 volume of structured products and structured notes SEC registered offerings of structured products amounted to $65 billion in gross sales. U.S. is now the third largest market of structured products globally, just behind Italy and Germany. 548 notes linked to Apple Inc. sold in the U.S., totaling $1.74 billion. 57% decline in sales of U.S. reverse convertibles.
This is MoFo. 30 Structured Notes Tax Treatment Bifurcation of debt instruments for tax purposes abandoned in Current accrual for contingent debt instruments, but not for other contingent financial instruments. Non-debt instruments are subject to the open-transaction doctrine – essentially a wait and see approach. SEC Disclosure Requirements SEC now requires issuers to disclose the issuer estimated value of structured notes on the cover page of the offering document. The estimated value is to be based on the value of the bond element and the derivative element of the structured note separately.
This is MoFo. 31 Structured Notes SEC Disclosure Requirements (continued) Sample disclosure: The estimated value of your notes at the time the terms of your notes were set on the trade date (as determined by reference to pricing models used by [issuer] and taking into account our credit spreads) was equal to approximately $974 per $1,000 face amount, which is less than the original issue price. The value of your notes at any time will reflect many factors and cannot be predicted; however, the price (not including [issuer]s customary bid and ask spreads) at which [issuer] would initially buy or sell notes (if it makes a market, which it is not obligated to do) and the value that [issuer] will initially use for account statements and otherwise equals approximately $990 per $1,000 face amount, which exceeds the estimated value of your notes as determined by reference to these models.
This is MoFo. 32 To ensure compliance with requirements imposed by the IRS, Morrison & Foerster LLP informs you that, if any advice concerning one or more U.S. Federal tax issues is contained in this communication (including any attachments), such advice is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Circular 230