Primer on Taxation of Investments

1. Primer on Taxation of Investments Tom Quinn - Moderator Dean Hindman Alan Fu

2. Agenda • Investment related tax issues • Debt/equity determination • Dividends and DRD • OID, market discount, etc. • Debt restructure/modification • Bad debt deductions • Partnerships • Derivatives and hedging • What and how derivatives are used • Hedging related issues • Timing of recognition rules under sections 1256 and 446

3. Taxation of Investments: Basics • Tax Basis • Generally will be the purchase price of asset • Upon disposition of asset taxpayer recognizes gain or loss equal to the difference between the amount received and the taxpayer’s tax basis in the asset • Character: Capital vs. Ordinary • Same tax rate applies to both capital and ordinary gain for corporations • Generally investment assets are capital assets • Property used in the taxpayer’s “ordinary course of trade or business” is ordinary in character • Holding Period: • Short-term capital gain/loss if held for < 1 year before disposition • Long-term capital gain/loss if held for > 1 year before disposition • Ordinary Income/Expense • Generally, includes interest income/expense and dividend income

4. Taxation of Investments: Basics (cont.) • Distinction between ordinary and capital • Capital loss is deductible only to the extent they can be netted against capital gains • Unused capital loss cannot be used to offset ordinary income • Capital losses can be carried back three years and carried forward five years • Capital loss cannot be carried back if it would create a NOL • If corporation has ordinary loss and a capital loss, the capital loss must be carried back first to a year in which capital gain can be offset and any gains remaining can be offset by NOLs

5. Debt versus Equity Investments • Section 385 • Determining if a particular investment is debt or equity • Notice 94-47 • Corporate and non-corporate entities • Partnerships, LLCs, Trusts • Investments that have both debt and equity characteristics are referred to as “hybrids” • Highly fact dependent • Perpetual debt • Mandatory redeemable preferred stock • Convertible debt • Pass-thru trust certificates

6. Taxation of Dividend Income • Section 316 • Dividends: distribution out of current or accumulated earnings and profit (E&P) • Sections 241-246 • Dividends Received Deduction (“DRD”) • Prevents triple taxation (double taxation still allowed on corporate earnings and individual shareholder) • Corporations are allowed a 70% deduction for dividends received from domestic corporations • 100% deduction is provided for dividends received within the same affiliated group of corporations • Limitation on aggregate DRD (“donut hole” limitation of section 246(b)) • Holding period requirement of section 246(c)

7. Taxation of Debt Instruments • Taxable interest income arises from “qualified stated interest” (QSI) or “original issue discount” (OID) • QSI is stated interest that is: • Unconditionally payable • Payable at least annually • At a single fixed (or qualified variable) rate, provided the rate appropriately takes into account the length of intervals between payments • Payable in cash or property, other than debt of the issuer

8. Taxation of Debt Instruments (cont.) • Sections 1271-1275 • OID is the difference between the stated redemption price at maturity (SRPM) and the issue price • SRPM is the sum of all payments under the debt instrument that are not QSI • If all stated interest is QSI, then the SRPM is simply the principal amount of the debt (face amount) • OID accrues over the life of the instrument using a single rate of compound interest, known as its yield to maturity • Holder of debt with OID must accrue income, and issuer of debt must accrued deduction, regardless of accounting method • Impact on basis • The basis is increased by each accrual of OID (as well as amounts treated as OID under a constant yield election) and decreased by each payment other than a payment of QSI

9. De Minimis OID • Section 1273(a)(3) • If OID with respect to a debt instrument is less than ¼ of 1 percent of the instrument’s SRPM multiplied by the number of full years from the issue date to the maturity date, the amount of OID on the instrument shall be considered zero for the holder and is subject to special timing rules for the issuer • Holder’s Treatment of De Minimis OID • A holder of a debt instrument with a de minimis OID recognizes gain when principal on the instrument is received. • The amount of gain recognized is equal to the product of the total amount of de minimis OID and a fraction the numerator of which is the amount of principal payment and the denominator of which is the total stated principal amount of the instruments. Thus, if principal is paid in full at one payment, the gain recognized is simply the de minimis OID amount. • Issuer’s Treatment of De Minimis OID • The issuer of a debt instrument with de minimis OID deducts OID regardless of whether it is de minimis • The issuer can elect to deduct at maturity, over the term of the instrument on a straight-line basis, in proportion to stated interest payments, or on a YTM basis

10. Market Discount • Sections 1276-1278 • A bond has market discount if its SRPM exceeds the tax basis of the bond immediately after its acquisition by the taxpayer by more than a de minimis amount. • The tax treatment of a market discount bond is as follows: • Gain recognized upon disposition (including a retirement or sale to a third party) of a market discount bond is treated as ordinary interest income to the extent of the accrued market discount as of the disposition date • A taxpayer can elect to include market discount in income as it accrues. If this election is made, IRC section 1277, which defers interest deductions allocable to accrued market discount, does not apply • If the bond is disposed of in a non-recognition transaction, special rules preserve the ordinary income taint as to the non-recognition property received in exchange for the discount bond • The discount is accrued on a straight-line basis or, if the holder elects, on a constant yield to maturity basis • The market discount rules have no impact on issuers

11. Market Discount (cont.) • The purpose of the market discount rules is to prevent the purchaser of debt at a discount from recognizing capital gain on the discount when its economic effect is to increase the stated yield of the instrument, just as OID does • Is there a difference between OID and market discount? • Market discount is not required to be included in income currently (but may be elected); rather, it is taken into account upon disposition of the instrument • Both are reported as interest income

12. Bond Premium • Section 171 • A holder acquires a bond at a premium if the holder's adjusted basis in the bond is greater than the bond’s SRPM • A holder can elect to amortize the bond premium over the term of the bond. The amount amortized for an accrual period, which is based on a constant yield method, offsets the interest income allocable to the period. A holder of a tax-exempt bond must amortize the bond premium • The basis of the bond is reduced each period for premium that is amortized • Bond issuance premium is the excess, if any, of the bond's issue price over its stated redemption price at maturity. In general, bond issuance premium allocable to an accrual period, which is based on a constant yield method, offsets the issuer's interest deductions for the period

13. Debt-for-Debt Exchange • Section 1.1001-3 (Cottage Savings Regs) • A debt-for-debt exchange occurs if the terms of an existing instrument are modified, and the modified debt instrument differs “materially either in kind or extent” from the original debt instrument • A physical exchange is not required – a deemed exchange of a debt instrument will occur if there is a “significant modification” of a debt instrument • In general, a modification is defined as an alteration in any legal right or obligation • The regulations are highly fact dependent

14. What’s a “Significant Modification”? • Generally, a modification is a significant modification if based on all the facts and circumstances the legal rights of obligations that are altered and the degree to which they are altered are economically significant • Where a series of modifications has taken place, the modifications are considered collectively, so a series of modifications may be significant even though the individual modifications are not

15. Examples of “Significant Modifications” • Significant modifications include: • Change of Yield of More Than 25 Basis Points. A change in the annual yield by more than: • ¼ of 1% (i.e., 25 basis points), or • 5% of the annual yield of the unmodified instrument (i.e., 0.05 x annualized yield) • Deferral of Scheduled Payments. A change in the timing of payments if it results in the material deferral of scheduled payments • There is a safe-harbor period for where the first scheduled payment is deferred and extends the scheduled payments for the lesser of (i) five years or (ii) 50% of the original term of the instrument

16. Examples of “Significant Modifications”(con’t) • New Obligor on Recourse Debt. Subject to limited exceptions, a substitution of a new obligor on a recourse debt instrument is a significant modification. • Alteration of Collateral on Recourse Debt. The alteration of (1) the collateral, (2) a guarantee, or (3) other form of credit enhancement relating to a recourse debt, if the modification results in a change in payment expectations. • Substantial Change in Collateral on Nonrecourse Debt. Subject to limited exceptions, (1) an alteration of a substantial amount of the collateral, (2) a change in guarantee, or (3) other form of credit enhancement relating to a nonrecourse debt instrument is a substantial modification.

17. Examples of “Significant Modifications”(cont.) • Change in Priority. A change in the priority of a debt instrument relative to other debt of the obligor if the change in priority results in a change in payment expectations • Change From Nonrecourse to Recourse. A change from a recourse debt to a nonrecourse debt or vice versa, subject to exceptions for (1) certain tax exempt bonds and (2) modification of a recourse debt instrument to a nonrecourse debt where the debt continues to be secured by the original collateral and the modification does not change payment expectations

18. What’s not a “Significant Modification”? • Modification by Operation of the Original Instrument. Generally, a significant modification doesn’t include an alteration that occurs by operation of the original instrument • This includes a unilateral exercise of a right under the instrument, subject to enumerated exceptions • However, a change in obligor or in the nature of the instrument from recourse to nonrecourse or vice versa is a significant modification even if it occurs by operation of the original debt instrument • Change in Accounting or Financial Covenants. A modification that adds, deletes or alters customary accounting or financial covenants is not a significant modification.

19. What’s not a “Significant Modification”? (cont.) • Failure to Perform. The failure of the obligor to perform under the debt obligation. • Agreement to Forbear. Agreement by the lender to forebear collection or temporarily waive an acceleration clause or similar default right, unless the forbearance exceeds (i) two years, (ii) any additional period in which the parties conduct good faith negotiations, or (iii) the borrower is in bankruptcy.

20. Bad Debts • Section 166 • Partial or total worthlessness deduction of debts that are not securities under section 165(g)(2) • Ordinary deduction rather than capital loss • Amount of deduction cannot exceed the amount charged off on the books • Industry Issue Resolution (IIR) update

21. Investment Held Through Partnerships • Sections 701 – 777 • Partnerships are generally not taxed at the entity level • Partnership’s income and loss flow through to the partners • Partner’s basis in its partnership interest is increased by its share of partnership income and decreased by its share of partnership losses and distributions • Partnership agreement generally sets forth the rules for how profits and losses are to be allocated among the partners

22. Financial derivative contracts • What are derivatives? • How are derivatives used? • How are derivatives taxed?

23. Points to note • IRS is aggressively auditing derivatives • IRS Industry Issue Resolution: Variable Annuity Hedging

24. What are derivatives? • Contracts between two counterparties providing for periodic payments that are “derived” from the performance of a specified asset or index • Common types of derivatives: -Options -Caps, Floors -Equity & Interest Rate Swaps -Regulated Futures Contracts -Forward Contracts -Swaptions

25. How are derivatives used? • Insurance companies use derivatives in many ways • Two common uses: -Hedge risks of duration mismatches between assets and liabilities -Hedge risk of liability for special benefits under variable annuity contracts

26. Duration hedging: What is duration, Why does it matter? • The duration of a financial asset that consists of fixed cash flows (e.g., a bond) is the weighted average of the times those cash flows are paid • The duration of an insurance company’s assets may be greater or less than the duration of its liabilities • Duration mismatches can result in either: (1) price risk or (2) reinvestment risk

27. Example #1: Price Risk • Suppose an insurance company issues a $100,000 life insurance policy and the insured has a 10 year life expectancy • Company matches assets with liabilities so that: PV of assets = PV of liabilities • Company buys a zero coupon bond that will mature in 14 years; will sell the bond in 10 years • There is a mismatch between asset duration (14 years) and liability duration (10 years) that creates price risk for the bond • If interest rates rise, the value of the bond will decrease • Sale proceeds of the bond in 10 years may not be sufficient to pay the $100,000 policy liability • There may be a “gap” between the assets and liabilities

28. Example #2: Reinvestment Risk • Suppose the same facts as in Example #1, but that the company buys a zero coupon bond that will mature in 6 years • There is a mismatch between the asset duration (6 years) and liability duration (10 years) that creates reinvestment risk • Here, this risk is that interest rates will fall • If rates fall, in year 6, the company may not be able to reinvest the bond maturity proceeds at a rate that will produce the $100,000 needed to pay the insurance contract liability in 10 years • There may be a “gap” between the assets and liabilities

29. Earnings from derivatives can compensate for the gap • In Example #1, a duration mismatch resulted in price risk • The company was vulnerable to an increase in interest rates, which would result in a decrease in the value of the bond • The company can hedge against this risk by purchasing a short position in either a Treasury futures contract or a short position in an interest rate swap

30. Treasury futures strategy • A Treasury futures contract is a bilateral contract between two counterparties that is traded on national security exchange • Under the contract, one counterparty agrees to purchase and the other party agrees to sell a Treasury security • Assume that company enters into a short position in a futures contract • If interest rates increase, the market price of Treasury securities will decrease • If rates increase, the company will be able to purchase a Treasury security in the spot market to meet its delivery obligations under the contract for a price that is less than the sales price it will receive under the contract • Futures profit hedges the bond price risk and helps to close the asset/liability gap

31. Interest rate swap strategy • An interest rate swap is a contract between two counterparties • One party agrees to make periodic payments equal to specified fixed rate times a specified “notional principal amount” • The other party agrees to make payments equal to a specified variable rate (e.g., LIBOR) times the notional principal amount • Suppose the company agrees to pay fixed and to receive variable payments under the swap • If the variable swap rate increases, the company will receive net periodic payments from the counterparty • Swap profit hedges the bond price risk and helps to close the asset/liability gap

32. How are derivatives taxed? • Code and the regulations include detailed provisions for taxing different types of derivatives; these include: -Code Section 1256 mark-to-market rules for futures contracts -Regulation section 1.446-3 timing rules for notional principal contracts (e.g., swaps) -Code section 1092 straddle rules -Code section 1221(b)(2) hedging transactions

33. Section 1092 straddle rules • The straddle rules apply in situations where the taxpayer holds offsetting positions in personal property • The rules defer deductions for losses that the taxpayer may realize with respect to one position to the extent that there is unrealized gain in the other position • Positions are offsetting if one position substantially diminishes the risk of loss in holding the other position • Because the positions tend to vary inversely in value, one position hedges against the risk of loss in the other position

34. Example #3Futures/Bond Straddle • Assume the company enters into a short position in a Treasury futures contract • Company also owns Treasury securities • Combination of short futures position and long portfolio position (directly owned Treasuries) is most likely a straddle • Suppose interest rates decrease; the value of Treasury securities will increase, the company will incur a loss under the futures contract • When can the company claim a loss deduction? • Straddle rules will defer the deduction for the futures contract loss if there is unrealized gain associated with the portfolio Treasury securities

35. Section 1221(b)(2) tax hedges • Insurance company purchases of derivatives may qualify as tax hedging transactions • Significance of tax hedging treatment: -Ordinary gain/loss -Income/loss from derivatives recognized according to section 1.446-4 hedge timing rules -Derivative losses exempt from straddle rules -Derivative income/loss exempt from section 1256 mark- to-market rules

36. When is a hedge a tax hedge? • Code section 1221(b)(2) definition -Transaction (e.g., a purchase of derivatives) to manage certain risks -Must identify the derivative as a hedge on the day it is purchased and identify the item hedged within 35 days

37. Qualifying risks • Risk of price changes or currency fluctuations with respect to ordinary property held by the taxpayer • Risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made or ordinary obligations incurred or to be incurred by the taxpayer

38. Does insurance company duration hedging qualify? • Duration (“Gap”) hedging manages price and reinvestment risk • If derivatives hedge assets, the hedge is not a tax hedge (assets are capital); must argue that derivatives hedge liabilities • IRS: Whether a Gap hedge hedges liabilities is a question of fact; depends on whether the hedge is more closely associated with liabilities than with assets [Preamble to section 1221 regulations] • Taxpayers: Sole reason for Gap hedging is to provide funds to pay liabilities

39. Section 1.446-4 hedge timing rules • If duration hedging qualifies as a tax hedge, then income/deduction, gain/loss from derivatives like futures and swaps is recognized according to hedge timing rules • Taxpayer must chose a method of accounting that reasonably matches income/deduction, gain/loss from derivatives with income/deduction, gain/loss from the item hedged

40. Hedge timing rules—cont. • The loss from futures contract in Example #3 must be matched against tax items associated with the item hedged • Taxpayers argue that the hedged item is an insurance contract liability • What are the tax items associated with an insurance contract: -premium income -decrease in reserve income -benefit payment deductions -increase in reserve deductions

41. Variable Annuity Hedging • Contract holders may choose to have their annuity benefits track the performance of equity markets • Some insurers offer special variable annuity benefits that guarantee a minimum monthly benefit or account value regardless of equity market performance • These insurers face the risk of declining equity markets, which will trigger their liability for special annuity benefits • Insurers hedge against this risk with derivatives like equity swaps

42. Are variable annuity hedges tax hedges? • Pending Industry Issue Resolution • Industry representatives, including the ACLI, are meeting with IRS officials • The industry argues that companies use equity derivatives like equity swaps to hedge liability to pay special variable annuity benefits • Open question: application of timing rules

43. Section 1256 • Derivatives are generally taxed on a realization basis as payments are made by the counterparties • But, section 1256 requires mark-to-market treatment at year end for open contracts that are “section 1256 contracts” • Section 1256 contracts include: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options and dealer security futures contracts • Recently enacted section 1256(b)(2)(B) clarfies that section 1256 does not apply to interest rate swaps and certain other types of derivatives

44. Section 1256—cont. • Section 1256 requires taxpayers to treat futures contracts held at year-end as if they were sold for their fair market value • 40% of total gain/loss treated as short-term capital gain/loss, 60% of total gain/loss treated as long-term gain/loss • Recall the long treasury futures position from Example 1 • In that example, we assumed that interest rates had declined; as a result the value of the taxpayers long position increased • Under section 1256, the taxpayer would have to treat this unrealized gain as taxable income

45. Section 1.446-3 Timing Rules for Notional Principal Contracts • Section 1.446-3 defines the term “notional principal contract” to include: -interest rate swaps -currency swaps -basis swaps -interest rate caps and floors -commodity swaps -equity and equity index swaps

46. Section 1.446-3—cont. • Section 1.446-3 prescribes method for taxing three types of payments that may be made under notional principal contracts: -periodic payments -non-periodic payments -termination payments

47. Periodic Payments • These are the monthly or quarterly payments exchanged by the counterparties at the fixed and variable rates specified in the contract • Periodic payments taxed on a cash basis as made or received • Section 1.446-3 does not discuss the character of periodic payments • The general consensus of practitioners is that periodic payments give rise to ordinary income and ordinary deductions

48. Non-Periodic Payments • These payments are made on a one-time basis usually to compensate one of the parties that is receiving an off-market payment • Non-periodic payments are amortized over the life of the contract according to a method specified in the regulations • Section 1.446-3 does not discuss the character of non-periodic payments • The general consensus of practitioners is that non-periodic payments give rise to ordinary income and ordinary deductions

49. Termination Payments • These are unscheduled payments made to terminate or assign a party’s remaining rights and obligations under a notional principal contract • Termination payments are usually deductible in the year a party’s rights are terminated or assigned • But, other provisions like the section 1092 straddle rules may alter the time that the termination payment is deductible

50. Termination payments—cont. • Character of termination payments is capital gain/loss (section 1234A, 1.1092(d)-1(c)(2)) • For a possible argument for ordinary treatment, see, Garlock, “The Proposed Notional Principal Contract Regulations: What’s Fixed? What’s Still Broken?”, 2004 TNT 56-26