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Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011

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.

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Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011

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  1. Taxation of Financial Products and TransactionsPracticing Law Institute -- Tax Policy Lessons From the Crash Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011

  2. 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.

  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 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?

  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 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?

  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 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?

  6. When interest rates go up… …Bond prices go down The Economics of Debt Prices: Interest Rates • Bond prices are sensitive to interest rates: $ % • 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

  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 2001 • Enron 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 one dollar, culminating in the next biggest bankruptcy in U.S. history

  11. The Distress Anomaly

  12. 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 II. Cancellation of Indebtedness and AHYDO

  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 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)

  14. 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))

  15. 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 II. Cancellation of Indebtedness Income and AHYDO

  16. 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 II. Cancellation of Indebtedness and AHYDO

  17. 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 II. Cancellation of Indebtedness and AHYDO

  18. 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 II. Cancellation of Indebtedness and AHYDO

  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 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

  20. 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 II. Cancellation of Indebtedness Income and AHYDO

  21. Deemed ExchangeIf 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) II. Cancellation of Indebtedness and AHYDO

  22. 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. II. Cancellation of Indebtedness and AHYDO

  23. 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 II. Cancellation of Indebtedness and AHYDO

  24. 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 II. Cancellation of Indebtedness and AHYDO

  25. 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 II. Cancellation of Indebtedness and AHYDO

  26. 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) II. Cancellation of Indebtedness and AHYDO

  27. 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 II. Cancellation of Indebtedness and AHYDO

  28. 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 II. Cancellation of Indebtedness and AHYDO

  29. 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 II. Cancellation of Indebtedness and AHYDO

  30. 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 II. Cancellation of Indebtedness and AHYDO

  31. 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 II. Cancellation of Indebtedness and AHYDO

  32. 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? II. Cancellation of Indebtedness and AHYDO

  33. 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 II. Cancellation of Indebtedness and AHYDO

  34. International Aspects of Financial Transactions • Broaden portfolio interest deduction • Expansion 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 concern • Was 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, unless . . . . • Congress 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?

  40. GUARANTEE GUARANTEE • Multiple Inclusions Exceed Borrowing • Pledge of CFC Stock U.S. Borrower Lender $1000 Lender U.S. Borrower $1000 ““Deemed Dividend” of $1000 “Deemed Dividend” of $1000 “Deemed Dividend” of $1000 Stock Pledge CFC (E&P = $1000) CFC (E&P = $1000) CFC (E&P = $1000) • Loan Exceeds FMV of CFC • Loan Exceeds FMV of Pledged Asset Lender $1000 Lender U.S. Borrower U.S. Borrower $1000 “Deemed Dividend” of $1000 “Deemed Dividend” of $1000 Guarantee CFC CFC (E&P = $1000) Pledge of $100 Asset Assets Assets Assets FMV = $500 E&P = $1000 FMV = $100 FMV = $2000

  41. Derivatives • Major issues • Credit derivatives • Dodd-Frank • Secondary issues

  42. 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

  43. 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/EurexClearinghouse

  44. 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

  45. 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

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