By Lee A. Sheppard -- firstname.lastname@example.org
Just when we thought that House Ways and Means Committee Chair Dave Camp, R-Mich., had put out a solid, sober proposal to nearly conform the tax treatment of derivatives to their financial accounting treatment, along comes The Huffington Post to liven things up with some wild assertions about the draft (http://www.huffingtonpost.com/2013/01/24/dave-camp-bank-tax-bill_n_2545894.html). Did no one fall out of her dress at the Screen Actors Guild Awards?
HuffPo suggested that the draft is revenge for financiers lobbying for the fiscal cliff deal, which caused Republicans to technically violate their tax pledge. Revenge is not implausible, but a lengthy financial plan would seem a rather roundabout route when tax increases like treatment of profits interests as ordinary income are drafted, estimated, and ready to roll. And as the article notes, Democrats are no more fond of the hypocritical Fix the Debt coalition than their GOP colleagues.
According to HuffPo, the Camp draft would "significantly increase taxes for the nation's largest banks." The story suggests that Wall Street will vehemently oppose the draft, even though a marking requirement for most derivatives was clearly on its way from the Treasury side. Indeed, the draft could be said to have jumped ahead of Treasury thinking (Tax Notes, Oct. 8, 2012, p. 121).
Most of the systemically dangerous banks that deal in derivatives are already section 475 taxpayers, marking to market everything in their dealer books. The five largest derivatives dealers are JPMorgan Chase, Goldman Sachs, Bank of America, Citigroup, and Deutsche Bank.
To the extent banks book derivatives onshore, their taxes would not increase in the dealer operations. Offshore contracts are eligible for deferral, which would not be affected by the draft.
Section 954(h), which was just renewed, allows dealers to defer income from many swaps in combination with reg. section 1.863-7, which sources income from notional principal contracts (NPCs) at the residence of the customer. Camp's 2011 territorial system draft would have made only minor conforming changes to subpart F, so section 954(h) might not have been affected.
The Camp proposal is highly pertinent to the customer side, where marking would be required for the first time. Individual customers would presumably be angry with banks that sold them magic beans. Taxable U.S. resident investors in hedge funds would be affected because they are not eligible for deferral and are rarely hedging. Many hedge fund tax planning tactics depend on derivatives.
Rich U.S. individual customers are fond of using derivatives like prepaid forwards to monetize their portfolios. Ordinary treatment for marks would strike them as harsh, but there is no capital treatment provided. And futures contracts would be marked but not entitled to 60/40 treatment under section 1256, which would be repealed.
HuffPo also claims that the Camp draft would implement the Volcker rule, which requires banks to limit proprietary trading when no customer is involved. Banks' prop trading is not in their dealer books, so it would have to be marked. Perhaps the incremental cost of taxes would be annoying. The Volcker rule allows customer-facing trading. (Prior coverage: Tax Notes, Mar. 12, 2012, p. 1339.)
Overall, it is hard to argue that the Camp draft has revenue in mind, because it contains a lot of technical items that taxpayers' representatives asked for previously. The cost of these taxpayer-comforting fixes would offset the cost of making non-dealers mark for the first time.
At the American Bar Association Section of Taxation Financial Transactions Committee meeting in Orlando, Fla., on January 25, practitioners and government officials dissected the Camp draft. The drafters of the Camp proposal relied heavily on a December 2011 report by members of the ABA tax section.
The discussants found provisions that were overdue in coming, but also strangely broad, overlapping, and unexplained in some aspects. Mark Perwien, special counsel to the IRS associate chief counsel (financial institutions and products), and Karl Walli, senior counsel (financial products) in Treasury's Office of Tax Legislative Counsel, joined in the fun.
Proposed section 485 would require all derivatives to be marked to market at the end of the year, regardless of whether some other rule of the code would prevent the resulting income or loss from being recognized. The marking requirement is intended to override other provisions of law, but the draft language does not say that.
Marked gains and losses would be considered ordinary. The termination, transfer, or expiration of a derivative would also be considered ordinary.
Marked losses would be "treated for purposes of section 172(d)(4) as attributable to a trade or business of the taxpayer." Whether or not the taxpayer had a trade or business, the loss could be used under section 172. So if the taxpayer were an individual investor, the loss would not be a miscellaneous itemized deduction subject to the 2 percent floor.
Proposed section 486 would define derivatives broadly to include any evidence of an interest in (or any derivative financial instrument with respect to) shares, partnership interests, debts, real property, commodities, currencies, NPCs, and other derivatives. An option on an option would have to be marked. Naked credit default swaps would have to be marked.
Although it is obvious that the drafters wanted to exclude direct ownership of the referenced asset, "evidence of an interest in" certainly encompasses direct ownership, Matthew Stevens of Ernst & Young LLP noted. "I don't think they intended that," he said.
Indeed, most brokerage customers do not own their shares directly. Panelists wondered whether American depository receipts and shares restricted by section 83 would be considered derivatives. Many compensation schemes, like phantom shares, are derivatives. Section 83 allows the parties to defer recognition of compensation income.
The referenced asset need not be publicly traded, which shocked practitioners. Section 1256 hinges on public trading and regular marking for its mark-to-market requirement. Indeed, daily exchange marking of the contracts was the impetus for Congress to act. Section 1256 would be repealed, taking 60/40 treatment with it, and futures would be marked as wholly ordinary.
Perwien wondered aloud how marking could be enforced when the referenced asset is not traded. He satisfied himself that most derivatives are on something traded, so the dealer can make a market. But the draft statute clearly contemplates marking when there is no public market, Mark H. Leeds of Mayer Brown LLP noted. Because Accounting Standards Codification (ASC) Topic 815 requires all derivatives to be marked, the proposal makes a lot of sense for taxpayers who have generally accepted accounting principles financials, Perwien added.
Treasury has proposed regulations (REG-111283-11) broadening the definition of NPC to include credit default swaps and weather derivatives. Should those regulations be finalized? Walli responded that he was not worried about the differences between the proposed regulations and the draft because the Camp proposal is merely a discussion draft, not a polished product. The draft picks up Treasury's proposed payment rule.
Walli called the breadth of the proposals "an eye-opener." To him, the big takeaway, cutting through the linguistics, was putting all derivatives in the categories of marked contracts or proven hedges. Holders of weather derivatives may well be hedging anyway.
The panelists were unable to agree whether the weather is a specified index. The technical explanation of the Camp draft states that weather derivatives were intended to be excluded. But the draft itself states that a specified index does not have to be economic information, just any information the parties do not control.
The draft defines a specified index as any one or more of (or any combination of) a rate, price, or amount (whether fixed or variable); any index based on any information (including the occurrence or nonoccurrence of any event) that is not within the control of any of the parties to the instrument and is not unique to any of the parties' circumstances; and any other index as the Treasury secretary may prescribe.
Another concept in the draft, apparently inspired by ASC 815, is that of embedded derivatives, which would be defined as derivatives. The Camp draft would require that the derivative component of a debt be marked, while the rest of the debt would be left alone. Convertibles would be covered by proposed section 486(d)(2).
The mechanism for segregating and valuing the embedded derivative is awkward. Proposed section 485(e)(3) would require that both parts be marked. Then the derivative component would be valued at the difference between the value of the debt with the derivative and the value without it -- a residual. Valuation would be difficult if the debt were not traded.
Would issuers be affected? Eileen Marshall of Wilson Sonsini Goodrich & Rosati asked. Presumably not, according to David Garlock of E&Y. But if that question is not cleared up, the issuer could have original issue discount on the debt component. The draft should not be read as requiring real bifurcation, he argued.
Under current law, convertibles are left alone while contingent debt is subject to special rules. The Camp draft would reverse this by excluding contingent debt from the marking requirement. Panelists were baffled; most contingencies would seem to be derivatives because they refer to the value of assets.
Technically, a nonfunctional-currency-denominated loan in the hands of the holder or the borrower could be a derivative under the draft, because the currency aspect is a short position, Chip Harter of PricewaterhouseCoopers LLP explained.
But the draft states that a debt denominated in a nonfunctional currency or having payments determined by a nonfunctional currency would not be considered to have an embedded derivative. The drafters intended to treat these loans as not having embedded derivatives, which may be evidence of a further intent not to treat the whole loan as a derivative, Harter mused.
Over the years, many securities business practices have been accommodated by the tax law to prevent untoward recognition events. The Camp draft would upend all that by calling them derivatives. A short position or a securities loan would be a derivative because the customer has exchanged the physical for a contractual right.
"Suppose you don't know your broker lent out the shares? Another good reason not to use margin accounts," said Leeds.
"Economically, a securities lending transaction has always been a derivative," said Walli, who was amused. "Hello, people! This is your first derivative from back in the day. It's a radical transformation," he said.
Is rehypothecation a derivative? Leeds suggested that a derivative could theoretically be present any time the broker had the right to lend the taxpayer's securities. Perwien noted that a taxpayer could borrow shares, take a marked loss on the borrowed shares, and give the shares back early the next year, effectively converting capital loss to ordinary loss. He added that this problem should be fixed.
The panelists agreed that repos would still be treated as secured loans and not be affected by the draft. Leeds noted that there would be a huge premium on whether a transaction was a securities loan or a repo. "An excellent point," said Walli. "The hardest thing is trying to figure out the scope of a provision."
The IRS has been highly resistant to mark-to-market losses on some of the garbage that lurks on banks' books. But Harter noted that had it been in place in 2008, the Camp draft could have given banks carte blanche to mark down the collateralized debt obligations, collateralized loan obligations, and other depreciated holdings in their investment books (where they moved the stuff to avoid marking it for book purposes). "It's TARP on automatic pilot," Harter joked.
What about letters of credit and loan commitments? Technically, those could be derivatives, Leeds suggested. The value of these contracts can be affected when the prospective borrower's credit quality deteriorates, and accountants make banks mark them to market on the view that the commitments were put options.
Merger and purchase agreements often contain earn-outs and other contingencies. If an agreement spans year-end, an embedded derivative must be marked. Or a plain vanilla contract with a delay built in -- the usual practice to allow time for due diligence -- could even be considered a forward contract. The panelists thought that the exceptions for variable rate debt instruments and contingent payment debts were inconsistent with the potential for purchase contracts to be marked.
Variable annuities would have to be marked to market. Life insurers sell these products as tax-advantaged mutual funds. They will not be best pleased by the proposed change.
The proposed hedging rule of section 486(f) and restated section 1221(c) is designed to excuse GAAP taxpayers that have already identified their hedges on their books from further identification for tax purposes (reg. section 1.1221-2). For these taxpayers, the draft is very convenient, even though the current regulations have an out for inadvertent failures to identify hedges (reg. section 1.1221-2(g)(2)(ii)).
For others, the draft could be a trap for the unwary, according to Perwien. If a hedge does not qualify for ASC 815, but did qualify under more indulgent tax criteria, it would have to be separately identified on the day it was entered. And if both sides of the hedge were contracts subject to marking for book purposes, the taxpayer would need to identify a hedge separately.
With all derivatives marked and ordinary, does it really matter if a taxpayer falls out of hedge treatment? Insurance companies can be expected to complain about the application of mark to market to one side of their Hoover hedges, which are not eligible for hedge treatment for tax purposes.
For debts denominated in a nonfunctional currency, the draft refers taxpayers to the section 988(d) hedge integration rules. Harter saw a problem in the draft's failure to delineate the treatment of holders of foreign-currency-denominated debt, who might be holding it as a capital asset. "It puts pressure on the definition of hedge," he said.
Stevens observed that the fate of reg. section 1.1275-6 is uncertain for holders of debt as a capital asset, for which hedge treatment is not available. If the offset is imperfect, the taxpayer would have only the derivative side of the arrangement marked. The technical explanation of the draft does not mention this regulation, which allows integrated treatment of a debt held or issued by the taxpayer and its hedge.
The pressure on the definition of hedge is increased by the proposed new rules for mixed straddles.
Current law requires taxpayers to recognize both gains and losses upon entering into identified mixed straddles, which consist of a marked section 1256 contract and an unmarked, usually long position (section 1092(b)(2) and reg. section 1.1092-3T(b)(6)). Taxpayers use identified mixed straddles affirmatively to accelerate gains and freshen capital losses, Erika W. Nijenhuis of Cleary Gottlieb Steen & Hamilton LLP noted at an ABA session on mixed straddles.
Nijenhuis and David Golden of E&Y had a romp through the various schemes taxpayers used at the end of last year to accelerate gain before the rate increase while hanging on to their assets. The IRS expressed concern about these tactics, but some of them were expressly sanctioned by regulation. And the system operates on the realization requirement -- taxpayers are allowed to time their gains.
Mixed straddles are not complicated to construct. Suppose the taxpayer owns an appreciated Treasury bond. It buys a short futures contract, recognizes the gain as though the bond was sold, and pulls off the contract the next day. The regulations explicitly sanction this, although some taxpayers waited more than a day to get rid of the futures contract (reg. section 1.1092-3T(b)(4), Example 1).
A straddle requires a substantial diminution of the risk of loss (section 1092(c)(2)(A)). A short Treasury futures contract may not provide enough risk diminution for a corporate bond in the zero-interest-rate era, Walli suggested. He cautioned that it can be difficult to prove correlation when a taxpayer is trying to affirmatively establish a straddle.
But the government appears unlikely to argue that taxpayers' identified mixed straddles are not straddles. The government absolutely has a long-run interest in maintaining a broad concept of substantial diminution, Walli added.
Isn't offsetting the interest rate risk enough? Nijenhuis noted that the government once argued that hedging preferred equity with short Treasury futures is a straddle, showing the breadth of the risk diminution concept. Walli's point was that the zero-interest-rate policy makes interest rate offsets ineffective.
The aspect of the year-end planning that offended some in government was that the purported straddle did not meaningfully alter the taxpayer's economic position. Nonetheless, "the bar is intentionally set low to be within the scope of the straddle rules," Walli said. "The whole concept of a straddle is that gains and losses move symmetrically at that point."
"If you create an asymmetry, sooner or later, taxpayers will figure out how to exploit it," said Nijenhuis.
Taxpayer tactics were not limited to mixed straddles. Taxpayers also sold and repurchased shares to take year-end gains. As Nijenhuis noted, there is no common law wash sale rule applicable to gains. The question has been litigated in the older straddle cases and in the lower courts in the decision that became Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991). Nijenhuis argued that Cottage Savings required only minimal difference between the positions.
Walli concurred that there need be only a minimal difference between the new asset and the old asset. The questions are whether the transaction is real and whether the taxpayer had economic risk in the arrangement. The taxpayer had to be taking the risk that the replacement asset would incur a loss.
If the transaction is wired, it might be a repo, Walli vaguely suggested. That is, the economic substance doctrine applies. Nijenhuis pointed to the IRS Large Business and International Division directive (LMSB-04-0910-024). She argued that the economic substance doctrine should not apply.
Taxpayers tried broken section 1058 transactions to recognize gains. A nonstandard fixed-term securities loan was held to be not covered by section 1058, so there would be a recognition event.
In Samueli v. Commissioner, 661 F.3d 399 (9th Cir. 2011), the Tax Court bifurcated the taxpayer's securities loan into a purchase and resale combined with a forward purchase contract.
The taxpayer bought $1.64 billion of market discount debt securities on margin, lent them back to his broker for cash collateral, and then used the cash to pay off the margin loan two years later. He could terminate the securities loan only on set dates during the term. The court held that this restriction deprived him of the benefits and burdens of ownership under section 1058(b)(3). The court concluded that no debt existed, so the cash collateral was the proceeds of a sale.
Taxpayers using standard documents attempted to fit within Samueli by returning their securities before term and incurring breakage fees. Nijenhuis was skeptical that this tactic had the desired effect of busting the loan. The taxpayer in the Samueli case had a custom agreement. Golden added that the Samueli court did not make a global statement about when securities loans fail section 1058, just that this taxpayer's special arrangement did fail.
Nijenhuis cautioned that the broken loan transaction should be real, with market risk, because a lender has not materially changed its economic position. Otherwise, the taxpayer could have a repo, so gain would not be accelerated. A fixed term is normal for repos, but there are no criteria for what is or is not a repo. The Camp draft would permit acceleration of gain, she argued.
Taxpayers could have tried to plan into constructive sale treatment of section 1259, but it is not easy to do. Golden pointed out that section 1259 is highly specific, although anything that satisfies it might also satisfy common law notions of constructive sale. The constructive sale mechanism, usually a swap, has to be kept in place for a month after year-end. Nijenhuis did not think that the government would go to the mat to push a taxpayer out of constructive sale treatment.
Thus far, section 1259 is ineffectual because numerous constructive sale transactions popular with rich individuals were excused from it at the behest of the vendors. Moreover, Treasury refused to issue rules implementing the residual category of section 1259(c)(1)(E) to pick up any other transactions. But the Camp draft's mixed straddle rule would obviate the need for section 1259.
The panelists characterized the Camp mixed straddle rule as "a super-section 1259 without a complete hedge being required." Walli said that if the Camp draft is enacted, "section 1259 serves no further purpose."
The Camp draft would abolish current law for mixed straddles and replace it with a rule that requires both sides of a mixed straddle to be marked. When a taxpayer entered a mixed straddle, built-in gain, but not loss, on the long side would be recognized.
Recognition of built-in loss would be deferred until disposition of the long position. So only gain or loss accruing while the straddle was on would be marked. Perwien called the Camp version "asymmetrical" in this regard.
A mixed straddle could be lopsided and nonetheless fall into the Camp rule. The proposed mixed straddle rule has no proportionality requirement, Harter noted. If there is any offset, the arrangement would be under the rule and marking would be required.
A lot of portfolio hedging is crude and imprecise, particularly when the long position is bonds. Or if a corporate parent makes a foreign currency loan to a subsidiary, it might have a mixed straddle for a crude currency hedge. Stevie Conlon of Wolters Kluwer added that inadvertent mixed straddles could make broker cost basis numbers inaccurate.
"This regime will really highlight the gaps in the hedging regime," said Harter. "We need to expand the hedging rules for purposes of this regime."
Average Cost Basis
The Clinton administration proposed average cost basis, which would clearly make life easier for brokers required to do cost basis reporting and makes it feasible. Cost basis would be determined on an account-by-account basis -- brokers can't know what else the taxpayer owns. Different holding periods would effectively split each account into long-term and short-term baskets.
The share identification rule is only a regulation (reg. section 1.1012-1(c)), but the rule could be considered legislatively reenacted, so it would be difficult to dislodge administratively, according to Walli. "It's an idea whose time has come," he said.
The wash sale rule of section 1091 would be extended to related parties. Spouses living apart and filing separate returns would be excluded. This would ratify Rev. Rul. 2008-5, 2008-1 C.B. 271, in which the IRS ruled that a taxpayer who caused his IRA to purchase shares identical to those he sold had a wash sale. Nonetheless, Rebecca Lee of PwC argued that the Camp draft could be read to question the reasoning of the ruling, which was controversial at the time.
Would the revamped wash sale rule allow a taxpayer to convert a capital loss into an ordinary loss? Options would be removed from section 1091. Jonathan Zelnik of KPMG LLP argued that because derivatives would be marked and the wash sale rule is confined to the physical, a taxpayer could retain a loss asset while putting on a derivative that would cement the loss as ordinary when marked.
HuffPo suggested that the Camp draft would enshrine debt relief for underwater mortgagors who are at risk of incurring cancellation of indebtedness (COD) income if their loans are modified. But section 108(a)(1)(E), which excludes COD income for principal residences, was extended to January 2014 by the American Taxpayer Relief Act of 2012 (P.L. 112-240).
The Camp draft would resuscitate repealed section 1275(a)(4), but only when the exchange of old debt for new debt was a reorganization. No COD income would be recognized when the principal amount remained the same and the new debt bore adequate stated interest. There would be no repurchase premium.
Vultures that obtain new debt in a taxable exchange would have COD income. The ABA report requested tax-free treatment of these holders on the view that the COD income is phantom income. Garlock mused that the ABA members should go back to Congress with an argument that holders should be accommodated, but he acknowledged that it would be "a heavier lift."
Vultures will no doubt be pleased with the proposed changes to the market discount rules (section 1278(a)(1)). Many had been refusing to accrue market discount, on the view that it was too much interest and that some diminution of value of the debt was due to deterioration in credit quality. The Camp bill would require accrual of market discount but would cap required accruals in a roundabout way.
An imputed principal amount would first be determined by discounting the bond by the greater of the yield to maturity at issuance plus 5 percentage points or the applicable federal rate plus 10 percentage points. Then the interest includable could not exceed the discount based on that imputed principal, even though the stated goal is to accrue based on the holder's adjusted basis.
Garlock was troubled by the proposed method of determining the issue price on which market discount would be accrued. The new imputed principal amount could be larger than the purchase price. A holder that bought at a low price should be allowed to accrue on that. "I think they're going to fix that," he said. Brokers would be required to report market discount.
According to Garlock, if a holder buys for 20 percent of the face amount and the yield cap under the new draft is 15 percent, the holder should have to accrue only $3 in the first year. If the holder had to accrue based on an imputed principal amount of 50 percent of face, the accrual would be $7.50, which would be a return of 37.5 percent of the actual investment. "That would defeat the purpose of the yield cap," he said.
Garlock wondered whether the new market discount rule superseded the common law doubtful collection precedent, on which some vultures rely for not accruing anything. Garlock mused that the new market discount rule should supersede all of that. The IRS does not believe that the old common law survived the 1984 enactment of section 1276. (Prior analysis: Tax Notes, May 26, 2008, p. 783.)
Garlock emphasized the need to fully integrate the rules for determining returns on market discount debt. "Why don't we just integrate everything? That would put the whole world on a section 1273 accrual," he asked rhetorically.
Garlock said that there would have to be special rules for asset-backed securities because prepayment assumptions would be required to accrue market discount. Lee noted that many holders are just following their books. Trouble is that book accounting is asymmetric, permitting accrual of a loss when the credit quality deteriorates but no accrual of gain when it appreciates.
Garlock wondered why bond premium should be an above-the-line deduction. Lee responded that under the new proposed and temporary section 171 regulations (REG-140437-12), the deduction of suspended bond premium could be suspended.
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