Why are we talking about fashion when women can’t leave the house to shop and wouldn’t have anywhere to wear stuff they bought online?
Retail sales were collapsing even before the coronavirus hit, and physical stores were already moribund. How do you short shopping malls? Carl Icahn has a complex $5 billion short position in the form of credit default swaps maturing in 2022 on a commercial mortgage-backed security index called CMBX 6. The United States has 1,100 malls, mortgages on 39 of which are in the CMBX 6 index.
But fashion is about renewal, and at some point, women will be looking for reset and renewal. Forced to stay home, Vogue denizens noticed — apparently for the first time — that they had too much crap in their closets and went for a reset. Some readers are doubtless wondering, really, are these self-absorbed Manhattanites really whingeing about not being able to eat out seven days a week or get their nails done? Yes, and let’s face it, Seinfeld never really was funny.
Indeed, new clothes may regain their physical appeal as shoppers worry about germs on used clothes. All fine in theory, but where’s the sense of renewal in further recycling of the ‘70s, the ‘90s, and the ‘00s? The aughts weren’t much good for anything, but models who were toddlers then are resurrecting some regrettable items like bucket hats and baggy pants.
Borrowers, among them retailers, are also looking for a reset. Of their loans. Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), lenders of all stripes are being required or encouraged to provide relief to borrowers. Nearly every loan readers’ clients hold is about to go into delinquency. But Congress didn’t think about the tax ramifications, except in the case of SBA loans to smaller employers. This article looks at those issues, but let’s spend a moment trying to keep fashion retailers going.
VSCO. It’s a photo-editing app and an eponymous teenage-girl style that could be described as very Southern California. It features Valley Girl staples like colorful barrettes, combined with gym clothes and sneakers. And no makeup. Yep, the youngest generation is eschewing lipstick, which should scare cosmetics companies.
Color. Spring green, purple, khaki. Other than that, loads of color. Even Brunello Cucinelli, the king of taupe, has become colorful.
Linen. Stay away from it. Linen is for tablecloths and bedsheets. It wrinkles when you look at it, becoming sloppy immediately, ruining the crisp, fresh idea that it is supposed to evoke.
Pants. Women can be their own worst enemies. They fought to be permitted to wear pants to work, and now they strive to dress like their grandmothers. There’s not much new to be said about pants, because we’re being flooded with dresses. Wide-leg pants, flared pants, and cropped pants are all current.
Edwardian. How’s that again? Who is wearing all this volume and where are they wearing it? Readers who are getting married will find it’s easy to buy something off the peg, but having a bunch of pointless alterations of the ceremonial gown is part of the ritual. There are velvet versions of these fantastic creations for fall.
Jackets. Double-breasted blazers and oversized jackets. Women are beginning to embrace shoulder pads. Jackets that button low rather than high are easier for women entre deux âges. Sweaters went big with boxy fits and dropped shoulders.
Baby-doll dresses. Are we kidding? Even Jean Paul Gaultier, who specialized in putting women in mannish suits, opened his last-ever show with a puff-sleeved baby-doll dress. And now Bergdorf Goodman wants to sell you a handmade baby-doll dress from a Danish designer. Go right ahead and buy one — in size 6-12 months, for your child or grandchild.
Bags. You love those buckets, so Prada and its little sister Miu Miu have a bucketload of them for you. Our favorite is the tan woven Prada bucket. Vuitton revived its ‘90s hard hatbox bag. Raffia bags, more suitable for the beach, are widely offered. Then again maybe some of you want a bag that looks like My Little Pony. That’d be the Vuitton Escale, with a pastel rainbow tie-dyed pattern.
Denim. Baggy and faded beyond recognition. Levis and others are threatening to bring back balloon-legged, high-waisted styles from the early ‘90s. There are varied offerings of denim skirts, which are a fish out of water because they’re too casual for dressy occasions and too dressy for denim occasions.
Preppy. Michael Kors did a spring collection of ramped-up preppy looks, including navy blue blazers, trench coats, and that resort favorite, lime green. Every man needs to own a good navy blue blazer to toss over everything, but it’s not clear that women need this garment because it doesn’t work quite as well with women’s staples.
Bermuda shorts. These are an improvement for those of you who need shorts but can’t wear Daisy Dukes. Do not wear them to the office, even with a matching jacket.
Sack dresses. Women are expected to wear what look like maternity clothes and bathing suit cover-ups in the middle of the day.
Mechanic jumpsuits. Who wants to leave the house looking like you’re going to work on transmissions?
Jewelry. Real yellow gold is being offered by actual jewelers who had hitherto specialized in pink gold for the Asian market. At the high end, Bulgari is making yellow gold again. For those who need a basic small plain yellow gold hoop, Le Gramme sells them singly. In rings, we’re seeing the return of signet rings and dome rings. Stacks of thick bangles are also current, to go with dresses.
Shoes. Square toes, straight out of the ‘90s. Some women think these are not graceful, but the honest truth is that men just don’t care what’s on your feet, so you might as well be comfortable. Women are trotting around offices in spiky high heels when the only ones who need to wear them to work are commentators sitting in “the leg chair” on Fox News.
Hair color. Hairdressers are closed for the coronavirus lockdown so some women took to dyeing their hair at home, with predictable results. Those with dyed-over gray can use root touch-up products available online (www.ritahazan.com). Men who are not in show business should use the opportunity to stop dyeing. The good news is that your teenage daughter’s expensively maintained purple hair is going by the wayside. In its place are obviously unnatural blond streaks that look homemade but aren’t.
Makeup. Coral lipstick, really? Even Selena Gomez, who is trying to sell makeup, doesn’t look good in it. And all of a sudden those of you entre deux âges could wake up with lip lines that look like you smoke even though you don’t. L’Oreal has a new Luminous Hydrating Lipstick with serum in it, that promises not to feather, for those who want to wear bright color. And please give your nails a rest during lockdown.
Dr. Deborah Birx. The big thing she does right is that she keeps her neck covered. She wears age-appropriate makeup, especially lipstick that is not too dark. Her hair is good. What’s wrong? Her outfits are kind of frumpy. Face powder should be avoided except for television — there are plenty of good matte foundations and sunblocks available.
Birx has been in government a long time, but doubtless didn’t become a physician to put herself on public display. Fashionistas are the opposite. They’re exhibitionists. They go to restaurants to be seen — one can’t eat a lot and fit into the clothes. Ever wonder how waiters keep plates and drinks balanced on a tray? The whole service-based economy is like that. One little slip and there is a cascade of bad consequences.
Like loans going bad. That affects banks, but a lot of them fobbed their commercial loans off to securitization vehicles and hedge funds. Our hypothetical lender is an offshore hedge fund with foreign investors that holds a loan to a U.S. borrower that was made by a U.S. bank that sold it to the fund immediately after making it. The fund may have participated in the negotiation of the loan. The fund takes the position that it is not engaged in a U.S. trade or business of lending, but that is not the subject of this article.
The borrower is going south, the fund is not enforcing loan terms, and everyone is wondering whether there has been a significant modification of the loan for purposes of section 1001. And yes, the borrower may well be a commercial landlord whose store tenants aren’t paying rent and won’t be able to for the foreseeable future, making the landlord unable to service its debt.
And yes, that loan may be eligible for compulsory or voluntary forbearance relief under the CARES Act. Sections 4022 and 4023 give borrowers of federally backed mortgages the right to request forbearance for 90 to 180 days, depending on the number of units in the building, with no fees or extra interest charged. Foreclosure is prohibited during that period.
Banks that kept loans on their books are being urged to be lenient and restructure them. Section 4013 of the CARES Act tells regulated lenders that they won’t have to take charge-offs or nonaccrual classifications for what would otherwise be impaired loans or troubled debt restructurings. So a lot of lenders are being encouraged to modify loans without the legislative drafters having given any thought to the tax effects.
Trouble is the tax regulations require recognition of a modification of the loan or even COD income to the borrower. The CARES Act drafters didn’t think through the tax ramifications of forbearance or other renegotiation. So lobbyists for some lenders are asking the IRS for some administrative relief, like they did during the financial meltdown of 2008.
The CARES Act requires forbearance only for mortgages. But it also permits bank forbearance and changes for other loans, with indulgence from regulators. So there will be a fair amount of action on loans. All kinds of other loans are becoming distressed, including commercial mortgages, credit card loans, auto loans, and consumer loans — many of which have been securitized or purchased, so are held by investors rather than the banks that made them. As we saw last week, some questions went unanswered in the last round of bankruptcies and insolvencies a decade ago. (Prior analysis: Tax Notes Federal, Mar. 30, 2020, p. 2027.)
Forbearance
Temporary forbearance doesn’t cause much trouble.
What is forbearance? It is a lender’s temporary willingness not to collect interest or principal payments on a loan. It is by definition discretionary and not an exercise of the terms of the loan document. Indeed, it is a deliberate failure to exercise creditor default remedies. The question is whether the tax law allows the lender or the borrower not to recognize the restraint in enforcement as a change of terms. It’s not supposed to be permanent.
The Cottage Savings regulations define virtually any change in a debt that is not provided for in the original indenture as a modification. Then they ask whether the modification is significant (reg. section 1.1001-3). The regulations passed their 20th anniversary since finalization, untouched except for removal of references to credit ratings (T.D. 9533, T.D. 9637). Around here, we always said that Cottage Savings was a politically motivated decision to permit insolvent thrifts to harvest losses, but the IRS could not ignore it (Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991)).
Temporary forbearance by a creditor, however, is not a modification, as long as it is really temporary. Under the regulations, a holder’s temporary forbearance, in the form of non-exercise of default rights, is not a modification. Temporary is presumed to be no longer than two years. Reg. section 1.1001-3(c)(4)(ii) states:
Notwithstanding paragraph (c)(1) of this section, absent a written or oral agreement to alter other terms of the debt instrument, an agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds —
(A) Two years following the issuer’s initial failure to perform; and
(B) Any additional period during which the parties conduct good faith negotiations or during which the issuer is in a title 11 or similar case (as defined in section 368(a)(3)(A)).
Three years ago, American Bar Association Section of Taxation members advocated for confining the temporary forbearance rule to related lenders. So an unrelated holder’s stay of collection or waiver of an acceleration clause (or similar payment default remedy) would not be treated as a modification regardless of how long the stay or waiver lasted. Conversely, related-party forbearance would be treated as an exchange of the debt for a demand loan if forbearance lasted longer than two years.
Lobbyists have asked the IRS to provide guidance ensuring that forbearance during the 180-day period mandated by the CARES Act will not result in a modification to a loan. They also want assurance that other coronavirus-inspired forbearance, documented or not, will be eligible for the forbearance safe harbor. (Click here for the Structured Finance Association letter to Treasury.)
It isn’t the forbearance period that causes the problem. It’s the potentially long period of deferral of payments due but not made during that period. The CARES Act permits past due payments to be made at the end of the loan term. Lobbyists want assurance that these curative payments will be protected by the safe harbor. Indeed, that curative period may be forever for residential mortgages. “Some borrowers are assuming, wrongly, that they don’t have to make up the payments later, industry officials and regulators say,” The Wall Street Journal reported (The Wall Street Journal, Apr. 3, 2020).
Another issue created by the CARES Act drafters is documentation. Section 4022 says that the lender is not permitted to require additional documentation when a borrower with a smaller building requests forbearance. That’s nice, and convenient for borrowers, but not so convenient for tax advisers trying to reconstruct what was done during an audit several years later. Lenders may have to show that their CARES Act loans are not in technical default.
The Cottage Savings regulations require small modifications to be aggregated to determine whether the combination rises to the level of a significant modification. So the lobbyists asked for IRS assurance that forbearance would not cause other documented changes to the loan to produce a modification in combination with it. That is, the request is that CARES Act forbearance would not be a factor when documented changes are aggregated for significant modification testing (reg. section 1.1001-3(f)(3)).
Deferral of Payments
If forbearance lapses into deferral, do subsequent past due payments have to be tested as modifications?
Literally, yes; the forbearance safe harbor doesn’t shelter past due payments subsequently made. Changes in the timing of payments beyond the two-year forbearance safe harbor period are significant modifications if material deferral is achieved.
A modification of the payment schedule is significant if it results in a material deferral of payments (reg. section 1.1001-3(e)(3)(i)). There is a safe harbor period for which deferred payments are not deemed material. The deferred payments must be unconditionally payable no later than the end of the safe harbor period (reg. section 1.1001-3(e)(3)(ii)).
The safe harbor period is generous. It begins on the original due date of the first scheduled payment that is deferred and ends at the sooner of five years later or 50 percent of the original term of the instrument, determined without regard to any option to extend. The unused portion of the safe harbor period can be tacked for any subsequent deferral of payments. Payments made outside the safe harbor deferral period must be tested for significance.
If the lender puts off pursuit of default remedies, and the borrower makes payments later than the forbearance safe harbor period, those payments have to be retested under the deferred payment rule. It is not clear what happens when a payment is late but within the forbearance period.
New York State Bar Association Tax Section members asked this question in the wake of the 2008 financial meltdown. The NYSBA lawyers asked whether a payment to cure the delinquency of the forbearance period would have to be retested under the deferred payment rules to see if there was a significant modification. They wanted an answer that said that delinquent cure payments would be covered by the forbearance safe harbor if they were still made within the forbearance period.
Lobbyists in 2020 identified this issue in the CARES Act and asked for explicit relief. The new law is intended to give mortgage borrowers until the end of the loan term to make payments that were due and unpaid during the forbearance period. That’s a longer time than the regulations seem to contemplate for past due payments subject to forbearance or permitted deferral. Some mortgage servicers are telling borrowers they owe a lump sum of past due payments at the end of the forbearance period.
The ABA members wanted a bright-line formula to measure the financial effect of deferred interest and principal payments (other than maturity extensions) to determine whether a modification was significant. For deferral payments, they wanted a mechanical rule based on multiplying each deferred payment by the period of the deferral. The sum of the products of these two numbers for all deferred payments would be tested for significance. The deferral would be significant if, and only if, the sum of these products exceeded the product of the principal amount of the debt and the specified deferral period.
Noting the ABA members’ recommendation, the NYSBA Tax Section suggested retaining the deferral safe harbor in its current form in a report recommending changes to the section 1001 rules for consent solicitations and exchange offers. They were worried that too many extensions would be treated as modifications.
Workouts
Well, gee, what happens when the borrower hasn’t made a payment, we’re outside the various safe harbor periods, and things still aren’t looking good?
Mere deterioration of the borrower’s financial capacity is not a modification (reg. section 1.1001-3(f)(2)). But changes in payment expectations can be a significant modification. On the downside, a change in payment expectations is a significant modification when “there is a substantial impairment of the obligor’s capacity to meet the payment obligations under a debt instrument and that capacity was adequate prior to the modification and is primarily speculative after the modification” (reg. section 1.1001-3(e)(4)(vi)(A)(2)).
The obligor’s capacity is further defined to include “any source for payment, including collateral, guarantees, or other credit enhancement” (reg. section 1.1001-3(e)(4)(vi)(B)). Given the generosity of the deferral safe harbor combined with the forbearance safe harbor, what are holders worried about? How long are they stringing borrowers along?
Our hedge fund lender has to think about salvaging its investment and about workouts. Our hedge fund has to think about the tax ramifications of participating in a workout, including effectively connected income questions.
Funds holding debt instruments don’t want to have to participate in workouts because of the ECI ramifications, but their participation may be inevitable. The contract for transfer of a loan from a bank to a hedge fund will specify whether the bank will continue to service the loan. If not, the fund will hire a U.S. servicer to do it. Then the servicing contract specifies what kind of decisions the servicer may take for a delinquent loan. As the owner, the fund has to sign off on the big decisions — the ones that create modifications.
The NYSBA lawyers pointed out that a hedge fund lender might be engaged in a U.S. trade or business of lending if it agrees to modify a loan and thereby reissues it under section 1001. A significant modification of a loan creates a deemed exchange and reissuance (reg. section 1.1001-3(b)). That reissuance would count as origination of a loan on U.S. soil. Even if there wasn’t a reissuance, other lender actions could constitute a lending trade or business, like DIP financing, bankruptcy exit loans, and cash advances in workouts. (Prior analysis: Tax Notes, Nov. 17, 2008, p. 778.)
Participating in workouts of debt, even if it was bought for investment, is not an investment activity (Whipple v. Commissioner, 373 U.S. 193 (1963)). Nor is participating in workouts a trading safe harbor activity (section 864(b)(2)). The statutory securities trading safe harbor encompasses all sorts of active portfolio management, but it is exclusive and does not expand to cover other activities of the trader (reg. section 1.864-2(c)(2); AM 2009-10).
Fund managers and agents may be forced to take actions in the United States that would be indicative of a U.S. trade or business of lending. U.S. resident managers who might travel to the fund’s place of residence to conduct business and conclude contracts might not be able to travel. They want to be able to argue that their actions are one-offs and not the conduct of a U.S. trade or business (reg. section 1.864-2(c)(1)).
If the fund is in a treaty country, it could have a permanent establishment through a dependent agent, even without a fixed place of business. So a Cayman investment and financial services company’s second-tier U.S. subsidiary, acting as a dependent agent, caused it to have a PE in the United States. The subsidiary continuously made investment decisions in the name of the Cayman parent according to the contract between the two. The parent had no other fixed place of business (Inverworld Inc. v. Commissioner, T.C. Memo. 1996-301).
Oh, but an unrelated U.S. agent can’t get the fund in trouble, can it? Aren’t unrelated servicers independent agents per se? Um, no. In AM 2009-010, the IRS concluded that an unrelated servicer that negotiated and serviced loans on behalf of a non-treaty foreign corporation with no office in the United States put the fund in a U.S. trade or business of lending (reg. section 1.864-4(c)(5)). The agent’s U.S. activities were “considerable, continuous and regular,” so its office was attributed to its foreign principal. The treaty analogy to this IRS position would be an agent creating a PE, that is, unrelated does not automatically equal independent.
Tax and Financial Accounting
Holders and investors may have other tax issues to worry about when loans are modified.
If the bank still held the loan, it would have to think about whether regulators would require it to cease interest accruals or post a loan loss on its books. That book hit may be taken earlier than a tax loss would be permitted (section 166; reg. section 1.166-2(d)(1)(i); LMSB-04-0110-003). The CARES Act allows banks to forgo charge-offs and nonaccrual classifications for delinquent loans still on their books (section 4013).
Pursuant to the CARES Act, an interagency task force of financial regulators and FASB promised not to treat short-term coronavirus-inspired modifications made in good faith as impaired loans or troubled debt restructurings, which could require a full or partial charge-off (ASC 310-40). Payment deferrals, fee waivers, and six-month extensions of term will not be considered troubled debt restructurings. Loans so modified need not be reported as nonaccrual assets in consolidated reports of condition (OCC Bulletin 2020-21).
A hedge fund or other investor doesn’t have to worry about capital requirements or regulatory accounting — which is why regulated lenders are fobbing loans off to unregulated investors in the first place. Some hedge funds are traders and have elected to mark their portfolios to market (section 475(f)). They would be inclined to mark down a dodgy loan even if it wasn’t publicly traded; they are probably already doing that for their books. Some investment funds with longer investor lockup periods do not mark their investments to market.
But a hedge fund does have to worry about how a dodgy loan it holds is treated for tax accounting purposes, as the NYSBA lawyers pointed out. Any payments that the borrower makes are allocated first to unpaid and accrued interest (reg. section 1.446-2(e)). But many bankruptcy plans allocate payments to principal first, with planners taking the position that the tax accounting rules do not apply. Outside bankruptcy, holders disregard the regulation. The New York lawyers asked for guidance.
A kissing cousin of this issue is the long-standing question whether a hedge fund that bought distressed debt has to accrue market discount when there is no reasonable expectation of repayment of principal. The IRS position is that the OID rules say what they say, and override ancient case law about recovery (TAM 9538007). Such a holder’s entire recovery could be taxed as market discount (section 1276(a)(3)). Not surprisingly, holders argue for capital gain treatment. (Prior analysis: Tax Notes, Jan. 22, 2018, p. 425.)
Mortgage Vehicles
Tax classification of securitization vehicles holding mortgages could be threatened.
Back to Icahn and his short position. He’s shorting mortgage-backed securities issued by securitization vehicles that own commercial mortgages. Many residential mortgages, now under compulsory forbearance, have been securitized. If those underlying mortgages are altered by forbearance or other negotiations, the desired tax classification of the securitization vehicle could be jeopardized. The penalty in all cases is entity-level taxation as a corporation.
So lobbyists asked for IRS assurance that mortgages that were the subject of (perhaps undocumented) forbearance are not treated as being in technical default, or as deemed new loans, threatening the qualification of the REMIC holding them (section 860G; reg. section 1.860G-2(b)(3)(i)). Debt is not supposed to be in bad condition when acquired by a REMIC, even though there is a continuing debate about the use of REMICs as workout factories. (Prior analysis: Tax Notes Federal, Jan. 20, 2020, p. 359.)
Not everyone uses REMICs for mortgage securitizations. Taxable mortgage pools could have a qualification issue if loans subject to forbearance were deemed to be in default. Taxable mortgage pools are not allowed to hold seriously impaired loans on the view that they are not debts at all (reg. section 301.7701(i)-1(c)(5)(i)). The safe harbor rule for residential mortgages allows a lender to treat a seriously impaired mortgage as good if it anticipates receiving relatively certain principal or interest payments (reg. section 301.7701(i)-1(c)(5)(ii)).
Likewise, grantor trust treatment could be jeopardized if loans subject to forbearance were deemed to have been modified. Consent to modification could be an impermissible power to vary the corpus on the part of the trustee. According to regulations and IRS ruling practice, grantor trust treatment for investors depends on the trust having a fixed pool of assets and no trustee power to vary them (reg. section 301.7701-4(c)). A trustee’s consent to changes in credit support for debt instruments held by a trust has been ruled not to be a power to vary (Rev. Rul. 90-63, 1990-2 C.B. 270).