Presentation on theme: "Taxation of Financial Products and Transactions Practicing Law Institute -- Tax Policy Lessons From the Crash Andrew Needham Matthew Stevens Michael."— Presentation transcript:
1 Taxation of Financial Products and Transactions Practicing Law Institute -- Tax Policy Lessons From the CrashAndrew NeedhamMatthew StevensMichael NoveyViva HammerJanuary 26, 2011
2 DisclaimerANY 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.6
3 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 bondMust 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 , the IRS concluded that the doubtful collectibility doctrine does not apply to OIDWas it right?What about the $800 of market discount?
4 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 debtUnder the statute, therefore, X acquired the bond at a “market discount” of $800Assume that X ultimately collects $400 on the bond, realizing a $200 gainX must therefore report the $200 gain as ordinary income, but only to the extent of the accrued “market discount”So what portion of the $200 gain represents “accrued” market discount?Is any of it market discount?
5 Do the Market Discount Rules Even Apply to Distressed Debt? No guidance from the IRS or Treasury. Must X continue to include the 10% interest as it accrues?The Priority Guidance Plan released in December by Treasury and the IRS includes “guidance relating to accruals of interest (including discount) on distressed debt”Until then, we are left with …Common Law – “Doubtful collectibility” doctrineTAMLegislative HistoryWhat about common sense?
6 The Economics of Debt Prices: Interest Rates Bond prices are sensitive to interest rates:When interest rates go up……Bond prices go down$%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 upThis is because the bond now pays interest at an “above market” rate, causing the price of the bond to rise
7 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
8 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
9 The Enron Debacle in 2001Enron bonds of every maturity converged to the same price, culminating in one of the largest bankruptcies in U.S. history
10 The WorldCom Debacle in 2002 WorldCom bonds of every maturity converged to within onedollar, culminating in the next biggest bankruptcy in U.S. history
11 The Distress Anomaly The 2 Year Bond The 20 Year Bond Issue Price $1000RankSubordinatedCoupon4%7%“Revised” Issue Price$500Nominal Yield79%16%Ultimate Settlement Amount$700Total Gain$200Interest component$8Capital gain component$0$192Should be :10 minutes in. Then will have 5 minutes of questions.
12 II. Cancellation of Indebtedness and AHYDO ProblemDebt market disruptedMarket deteriorated suddenly. Trouble began in 2007, spiked in late 2008Thin tradingLow market pricesSpreads widenedGovernment 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 bpPeaked at over 460 bp in October 2008
13 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 possibleValuation rules define market value broadly.Leads to inappropriate triggering of:Recognition of income under the cancellation of indebtedness (COD) rules; andDisallowance of OID deductions under rules for certain high-yield debt obligations (the AHYDO rules)
14 II. Cancellation of Indebtedness and AHYDO Problem (cont’d)Virtually all bond trading done over-the-counter in privately negotiated transactionsPrices traditionally not publicly reportedMarket less liquid than equity marketAbout 80% of bonds did not trade in a typical month even before credit crisisOnly 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, (2000))
15 II. Cancellation of Indebtedness Income and AHYDO HypotheticalFactsBorrower issues debt instrument for $100 million at 6% coupon, 7 yr termBorrower amends terms of debt after 6 monthsTrades 50 bp increase in interest rate for adjustments in covenants.Term and principal amount unchangedMinimum tradingCurrent “bid” quotes for debt instrument listed on an electronic secondary market at 50 cents/dollar at time of amendmentLittle or no actual recent tradingTax 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
16 II. Cancellation of Indebtedness and AHYDO Law: Issue PriceIssue price is how the tax law values a debtDebt instruments issued for cash: Issue price is first price at which a substantial amount of the debt is sold for moneyIP of original debt instrument = $100 millionSee Regulations § (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 millionSee Regulations § (b)Law provides different valuation mechanism under IRC Section 1274 if there is no public trading and certain other conditions apply
17 II. Cancellation of Indebtedness and AHYDO Law: Issue Price (cont’d)“Publicly Traded Property” is defined broadly. See Regulations § (b)Exchange listed, e.g., listed on a national securities exchangeMarket traded, e.g., traded on an interbank marketAppears on a quotation mediumIncludes a computer listing disseminated to subscribing brokers, dealers, or traders containing recent price quotes, e.g., MarketCraig’s List for debt instruments?Readily quotable, i.e., price quotes readily available from dealers, brokers or traders
18 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 § (f)Exchange listed, e.g., listed on a national securities exchangeSales price of an executed purchase or sale is reasonably availableFirm quotesPrice quote is available from at least one broker, dealer or pricing serviceQuoted price is substantially the same as the price at which it could be soldThe identity of the party providing the quote must be reasonably ascertainableIndicative QuotesPrice quote is available from at least one broker, dealer or pricing service and the quote is not a firm quote
19 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 millionSmall 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
20 II. Cancellation of Indebtedness Income and AHYDO Law: Debt Modifications. See Regulations § (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” modificationDoes not distinguish between an increase or decrease in the borrower’s burdenExamples (non-exclusive list):Change in interest rate (up or down); andChange in principal amount (up or down)Is it debt?Final regulations issued under section (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
21 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 IncomeIssuer recognizes COD income upon repurchase of a debt instrument for an amount less than its adjusted issue price. See Regulations § (c)(2)(ii)
22 II. Cancellation of Indebtedness and AHYDO Example: CODFacts$100 million debtCovenants are modified in return for 50 bp increase in interest rateModified debt trades at 50% of face on thin secondary marketIssue PriceOld debt: $100 million, measured by cash proceedsNew debt: $50 million, measured by market quoteCOD: IP of old debt minus IP of new debt = $50 millionResult: Debtor is taxed as if it received $50 million of income, even though its obligation under the debt instrument was increased in the transaction.
23 II. Cancellation of Indebtedness and AHYDO Law: AHYDO. See IRC Sections 163(i) and (e)(5)AHYDO DefinitionTerm greater than 5 yearsYield greater than AFR + 5%“Significant OID”AHYDO RulesPortion 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 transactionRemaining OID only deductible when paidIncreases timing mis-match between the COD and OID created by the same transaction
24 II. Cancellation of Indebtedness and AHYDO Example: AHYDO DefinitionFactsBorrower issues debt instrument for $100 million at 6% coupon, 7 yr termBorrower amends terms of debt after 6 monthsTrades 50 bp increase in interest rate for adjustments in covenants.Term and principal amount unchangedMinimum tradingCurrent “bid” quotes for debt instrument listed on an electronic secondary market at 50 cents/dollar at time of amendmentLittle or no actual recent trading
25 II. Cancellation of Indebtedness and AHYDO Example: AHYDO Definition (cont’d)New debt instrument is an AHYDOTerm of 6.5 years is greater than 5 yearsYield of 21% is greater than AFR plus 5%Yield calculated from new issue priceCurrent AFR is 1.92%, so bar is now at 6.92%.Significant OIDOID = SRPM minus IP = $50 millionTest 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
26 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 OIDExampleOID = $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)
27 II. Cancellation of Indebtedness and AHYDO Example: AHYDO Definition (cont’d)Result:Debtor realizes $50M in COD income;Debtor allowed $0 offsetting OID deductions; andDebtor owes same principal amount, over same term, at a higher interest rateReason: Issue price re-set to value of low market quote because of the debt modification
28 II. Cancellation of Indebtedness and AHYDO Interaction of RulesCOD normally offset by OID deductionsCOD = IP(old) minus IP(new) = $50 millionOID = SRPM minus IP(new) = $50 millionImperfect offset because of timing differenceThis offset disrupted by the AHYDO rulesDisallows some or all of the OID deductions that correspond to the COD inclusionAny remaining OID deductions deferredRemainder deductible when paid (instead of when accrued)Worsens original timing difference between COD inclusion and OID deductions
29 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 dividendsReal-world consequencesCOD creating large, unexpected income inclusions.Can create immediate cash tax liability if issuer does not have enough NOLs to offset the COD incomeEven issuers in serious financial trouble today have not necessarily built up sufficient NOLs to offset a sudden COD income inclusion from a debt modification
30 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 2011Recognize COD over 5-year period, beginning in 2014.Must also defer corresponding OID deductions to match COD inclusions with OID deductionsApplies to COD from debt reacquisitions.By issuer or related personFor cash, new debt, or corporate stock or partnership interest if debt contributed to capitalIncludes debt modificationsIncludes 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
31 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 debtIn debt-for-debt exchange (or modification)Old debt not an AHYDOAfter August 31, 2008 or in 2009Notice extended the AHYDO suspension for new debt issued during No extension for 2011 so far.No change in obligor, no contingent portfolio interest, no debts issued to related personsSubsequent exchanges with same effective dates.Treasury granted authority to -Extend suspension of AHYDO rules into the futureTemporarily substitute a higher rate for the AFR in the definition of AHYDO after 2009Both permitted if conditions in the debt capital markets continue to be distressed
32 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 priceIs 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?
33 II. Cancellation of Indebtedness and AHYDO SummaryDebt modifications trigger COD and AHYDO rulesTax rules value debt according to market value where possibleMarket values plummeted suddenly due to disruption in credit marketsDebtors surprised by tax effectsTemporary relief available for transactions occurring in 2009 or 2010Will this temporary relief be extended for 2011?Opportunity to craft permanent fixesShould be :30-35 minutes in.
34 International Aspects of Financial Transactions Broaden portfolio interest deductionExpansion of section 956
35 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
36 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)?
37 Expansion of portfolio interest exemption from withholding tax What about the exclusion for banks?More a regulatory concern than a tax concernWas this ever justified?Does it make sense to force the banks to originate the loans, and then sell them to hedge funds?
38 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, unlessCongress adopts a “portfolio dividend” provision
39 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?
41 Derivatives Major issues Credit derivatives Dodd-Frank Secondary issues
42 Derivatives Credit Default Swaps TRS and other credit derivatives all converged in CDSNeed for regulating CDSSelf regulation – big bangFederal govt. regulation – Dodd-FrankTax treatmentNever settled prior to Dodd-Frank, several approachesPost Dodd-Frank with clearinghouses and standardization
43 Derivatives CDS Clearinghouse Operations Clearinghouse Corporation/Intercontinental Exchange ClearinghouseRegulated by New York banking department and Federal ReserveTrades negotiated OTC, then submitted to clearinghouseClearinghouse becomes sole counterparty; daily netting occurs.Index contracts only initiallyParticipants currently limited to banks and broker-dealers.Chicago Mercantile Exchange/Citadel Exchange and ClearinghouseTrades entered into on exchangeOtherwise expected to function similarlyEuropean ClearinghouseLiffe/LCH-Clearnet Clearinghouse (launched December 2008).NYSE Euronext/Eurex Clearinghouse
44 Derivatives Tax Issues Clearinghouse is not an exchange Effect on insurance/guarantee vs. derivative issueEffect 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
45 Derivatives Secondary issues Mark to market for a broader class of instrumentsAccrual of income on prepaid forwardsNonrecognition of gain or loss on securities loans4545