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KPMG Expects Significant Tax Consequences of Wall Street Reform

MAY 1, 2011

KPMG Expects Significant Tax Consequences of Wall Street Reform

DATED MAY 1, 2011
DOCUMENT ATTRIBUTES
An Introduction to the Tax Implications of the Dodd-Frank Wall Street Reform and Consumer Protection Act
The sweeping reforms brought on by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act)1 will impact nearly every aspect of the financial services industry. Although the Act contains only one tax provision, the Act nevertheless raises a number of important tax considerations for financial institutions. This Introduction provides an overview of those areas of the Act that are most likely to raise significant tax issues.

Executive Summary

This Introduction focuses on the following areas:

Living wills -- Large financial institutions will be required to create living wills. The living wills are likely to have both recovery plans (remediation steps for financially stressed institutions) and resolution plans (wind up plans). Most recovery plans will require some form of restructuring (both immediate steps to make the plan viable and steps in the future if the plan is implemented), and resolution plans will entail dispositions. These restructuring and disposition transactions will raise many tax issues.

Volcker Rule -- The Volcker Rule prohibits "banking entities" from engaging in "proprietary trading" and severely limits banking entities from investing in hedge funds and private equity funds. Many institutions will restructure their businesses to address this rule, raising a similar set of tax issues as those raised by living wills.

Derivatives -- Trading in many derivatives will need to be cleared, exchange traded and reported publicly. The new rules raise questions about the coverage of IRC section 1256 and the treatment of up-front payments likely to be made when certain swaps are exchange traded. Banking entities will be required by the Act to push out the trading in certain derivatives to affiliates, raising tax issues when the trading personnel and books are moved out of the banking entity.

Bank capital and liquidity -- Under the Act and related Basel III2 pronouncements, banks will be required to raise common equity capital and also issue contingent capital debt instruments. At the same time, trust preferred debt will not satisfy regulatory capital requirements in the future.

Absent guidance from the tax authorities, the treatment of the contingent capital debt instruments as true debt for tax purposes is quite uncertain.

Securitization -- Issuers will need to retain 5% interests in many securitization transactions under the Act. Guidance on these rules was issued in late March by several regulatory agencies. The main impact will depend on the form transactions take to meet the risk retention requirement, and any changes in the form of transactions may affect their taxation.

Executive compensation -- Provisions of the Act in this area are focused on (i) increased shareholder disclosure and nonbinding votes on executive compensation and golden parachute payments, (ii) recovery of compensation determined to be excessive or inaccurately determined after an accounting restatement, and (iii) independence of compensation committee members and outside advisers. The law requires the company to report and possibly prohibit incentive based compensation that could encourage excessive risk taking. Additional information will eventually be required reporting the average compensation of the employees and the CEO.

Living Wills

The Act's Provisions

Systemically important nonbank financial holding companies and large bank holding companies (Bank Holdcos) (collectively, SIHCs) must prepare recovery and resolution plans (so-called "living wills").3 SIHCs are defined generally as those institutions with over $50 billion in consolidated assets.4 Recovery plans are designed to detail what an SIHC would do to deal with capital and liquidity short-falls under circumstances of extreme duress. For example, SIHCs may be asked to indicate which businesses in an emergency would be sold or run down, which trading books would be liquidated, and how a sale of the entire entity to a third party would be implemented. Resolution plans are designed to give the regulators sufficient information to permit them to take control of an institution and provide for its orderly liquidation.

Timing

Not later than 18 months after the date of enactment of the Act, the banking regulators are to issue regulations covering the creation of living wills and establishing a time frame for their implementation. Some large financial institutions have already been required to submit living wills pursuant to existing bank regulatory powers.

Tax Issues

From a tax perspective, among the key elements of living wills are (i) identifying all legal entities having regulatory significance and inventorying the tax attributes of these entities and the relationships and transactions among them, (ii) determining how, in the event of duress, businesses, assets, or entities would be separated from the group and how inter-relationships would be severed, (iii) evaluating the impact of any internal restructurings and capital raising provided for in a living will, and (iv) analyzing the side effects of any of these measures.

No two institutions will have the same set of issues. However, we expect the common tax issues to include, among others:

Dispositions and other restructurings -- What assets or businesses need to be isolated in discrete entities so that they can readily be sold or run down without affecting other businesses? What are the expected tax consequences of dispositions and other restructuring transactions (taking into account the potential for insolvent or worthless entities)?

Will limitations on the use or recognition of losses or other tax attributes come into play?5 In the case of foreign entities, will any gain recognition agreements be triggered?6 If assets used outside the United States or shares in a controlled foreign corporation are disposed of, will an overall foreign loss be recaptured?

Intercompany tax sharing agreements -- How will existing tax sharing agreements be affected by any restructuring? In the event an entity is actually disposed of, how will any liabilities relating to years when it was owned by the group be treated?

Consolidated return issues -- Will the recognition of gains or losses from deferred intercompany transactions be accelerated into income?7 Will excess loss accounts be triggered?8 Which losses will be limited by the unified loss rule?9

Intercompany sales -- Will transfers of assets between members of a consolidated group create deferred intercompany gains or losses?10 Will assets be sold between controlled foreign corporations generating taxable gains or, possibly, disallowed losses?11 If assets are sold at book value but have a different fair market value, will there be a deemed dividend or capital contribution as a result of the off-market transaction?

Debt modifications -- Could changes affecting outstanding debt be considered "significant modifications" under the debt modification tax regulations, triggering cancellation of indebtedness income or having other tax effects?12

Tax residence and permanent establishment -- Will the restructuring of an entity cause it to be subject to the tax laws of a new jurisdiction? In the international context, will it have established a new permanent establishment?

Transfer pricing -- Will important business functions be shifted from one entity or one jurisdiction to another? If so, what adjustments to transfer pricing policies should be made?

Customer impact -- Will the restructuring transactions result in recognition transactions for customers,13 changes in withholding tax rates or otherwise impact customers of the institution?

A more fulsome list of tax restructuring issues is attached as Appendix A.

The Volcker Rule

The Act's Provisions

The Volcker Rule has two prongs. First, it prohibits "banking entities" and their affiliates from engaging in "proprietary trading." Second, it prohibits "banking entities" from sponsoring or investing in hedge funds and private equity funds subject to a de minimis exception.14 "Banking entities" are defined generally as FDIC insured banks and Bank Holdcos and their affiliates.

"Proprietary trading" is defined as engaging as a principal for the "trading account" of the banking entity. There are a number of permitted activities carved out of the rule, including trading in government securities, dealing in securities in connection with underwritings and market making activities, facilitating customer activities, and hedging the banking entity's own positions.

As for the de minimis exception, banking entities can own up to a 3% interest in a given fund subject to the limitation that the sum total of any such interests cannot exceed 3% of the Tier 1 capital of the institution. The total amount invested must also be subtracted from a banking entity's tangible capital in calculating its compliance with regulatory capital requirements.

Timing

Starting no later than two years after the date of enactment of the Act (or, within 12 months of the issuance of final regulations if this date is earlier), banking organizations have two years in which to divest or discontinue prohibited activities. Various rules exist to grandfather existing investments for periods up to five years after the effective date of the rule. Practically, many institutions have already begun the process of determining which businesses will need to be terminated and begun to plan for an orderly exit from these businesses.

Tax Issues

Many of the tax issues raised in the section above dealing with living wills will also apply to dispositions required by the Volcker Rule. In addition to these issues, a variety of issues relating to the establishment of new hedge funds will arise as proprietary traders organize new funds independent of the banking entities employing them.

Derivatives

The Act's Provisions

Clearing, trading, and reporting -- The Act regulates trading in "swaps" (instruments governed under the Act by the CFTC)15 and "security based swaps" (instruments governed under the Act by the SEC) (collectively, "swaps").16 The reach of the Act on swaps is quite broad. As a result, almost all derivative instruments traded by banks will be covered by the Act.

The Act imposes a number of regulatory requirements on "swap dealers" and on "major swap participants"/"major security-based swap participants" (collectively, "major swap participants"). Swap dealers constitute the financial institutions that today hold themselves out as dealing in swaps. Major swap participants generally are the entities that engage in substantial swaps activities and that hold significant swaps positions.

The Act requires the CFTC and the SEC to determine which swaps should be cleared. Practically, only swaps on which standardized terms can readily be imposed will be subject to the clearing rules. Swaps that are required to be cleared must be traded on a designated board of trade, a securities exchange or through a "swap execution facility" (a new form of entity created by the Act). Commercial end-users may elect to be exempted from the clearing requirement, and any swap that is not cleared need not be exchange traded. Hence, banks trading with commercial end users will be able to continue to do so as a principal to the swap transactions (unless the commercial end user opts to have the swap cleared).

The "Lincoln" provision or swap push-out rule17 -- This provision requires swap dealers that are banks or other entities having access to Federal Reserve credit or FDIC assistance to limit their swap dealing to certain permitted activities. These permitted activities include interest rate and currency swaps,18 cleared credit derivatives on investment grade securities, and the hedging activities directly related to permitted activities of the entity. Any activities not permitted to be performed must be terminated or moved to a non-bank affiliate of the Bank Holdco. These will include non-qualifying credit derivatives and equity and commodity derivatives. A bank is prohibited from providing any assistance to a related swaps dealer (including, according to the Act, providing "tax breaks").19 This provision applies to the U.S.-based activities of foreign financial institutions. The application of the push-out rule to foreign "Edge Act" subsidiaries of banks is unclear.20

Timing

The clearing, trading, and reporting requirements become effective 360 days after enactment of the Act. Swaps entered into before the effective date are exempted from the clearing requirements but still must be reported in accordance with the reporting rules. The push-out provision takes effect after an extended transition period (about five years in total from the date of enactment of the Act). Swap positions in existence when the push-out rule takes effect are grandfathered and need not be moved out of a banking entity. Many institutions will begin immediately to sort out where they want to trade derivative instruments and begin to plan any needed changes.

Tax Issues

Clearing, trading, and reporting -- The tax issues raised by the clearing, trading, and reporting provisions are clustered in two areas. The first has to do with the coverage of IRC section 1256; the second has to do with the treatment of up-front swap payments.

In an attempt to preserve the present law treatment of derivative contracts, Section 1601 of the Act provides that "section 1256 contracts" do not include:

 

Any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.

 

As more and more instruments have come to be traded on exchanges in the United States, the exact reach of section 1256 has become somewhat unclear. Since the language in section 1601 does not track definitions contained in the tax law, the language in the Act has contributed to this lack of clarity.21

More particularly, the list of transactions in section 1601 may be both slightly over-and under-inclusive. For example, both "equity swap" and "credit default swap" can be construed various ways for tax purposes. Did Congress intend to cover all permutations of these instruments in the carve-out from IRC section 1256 treatment?

Section 1601 includes the catchall phrase "or similar agreement." Given that certain swaps can be taxed various ways and economic swap positions can be synthetically created through a combination of derivative financial instruments, what is the scope of this category? Did Congress have certain financial instruments in mind when it added this category? Indeed, are any regularly seen swaps not included in the list in section 1601?

These types of issues will need to be sorted out by guidance provided by Treasury and the IRS.

Under the Act, many swaps will be required to be cleared and traded on established exchanges. Banks clearing derivative trades will be required to post collateral with the clearing organizations. This collateral may consist of cash and qualifying securities. With respect to the qualifying securities posted as collateral, banks will be expected to satisfy any withholding and information reporting responsibilities associated with those securities.22

Since only standardized swaps contracts can be exchange traded, swaps that reflect the credit worthiness of a particular company or a collection of companies will need an upfront payment to make the standardized terms of an exchange traded instrument fit the credit standing of the referenced entity or entities. This will be particularly true with respect to credit default swaps and may apply to other types of swaps as well.

For tax purposes, the upfront payment may be a significant non-periodic payment, and this may cause the swap to be bifurcated into an on-market swap and a deemed loan.23 The deemed loan can give rise to various tax issues.

For an offshore fund with a U.S. manager, the deemed loan can constitute origination activity, and the IRC section 864(b)(2) safe harbor for trading activities that will not constitute a U.S. trade or business may not be available for loan origination activity. This may subject the fund to U.S. federal income tax if the fund is found to be engaged in a U.S. trade or business.

The deemed loan may lead a U.S. tax-exempt organization to have income from investment property financed by indebtedness, and this income may be subject to tax under IRC section 514(a) dealing with unrelated debt-financed income.

Under IRC section 956, a controlled foreign corporation with a deemed loan to a 10% U.S. shareholder will have made an investment in U.S. property. As a result, the 10% U.S. shareholder may have a taxable income inclusion. Under the reverse pattern, a deemed loan from a 10% foreign shareholder of a U.S. corporation to a U.S. corporation may subject the foreign shareholder to 30% withholding tax on the deemed interest income on the loan, unless an income tax treaty reduces or eliminates the tax.24

Swap push-out rule -- The tax issues arising from the pushout rule will depend on how different institutions choose to arrange their swap dealing activities once the Act provisions become fully effective. Many Bank Holdcos already split some swap dealing activities between their bank and its subsidiaries and non-bank affiliates. Moreover, many institutions today book their swaps in one entity and trade off of that book in remote locations. For example, an institution may choose to book its entire non-U.S. dollar interest rate swap business in a U.K. based entity and all of its U.S. dollar interest rate swap activity in a U.S. bank. Traders may trade off of these books from a multitude of locations outside of the United States and the United Kingdom. In some cases, these books will be maintained in the bank and the traders trading off of the books will be employed both in the bank and in the non-bank affiliate.

Going forward, Bank Holdco's will need to decide whether they want to unify all of their swap dealings in a non-bank affiliate or whether they want to split this activity between their bank and non-bank affiliates. Assuming a Bank Holdco is required under the Act or otherwise decides to move some or all of its swap dealing activity from its bank to a non-bank affiliate, the Bank Holdco will need to review its current trading pattern and decide which books and people it will need to move to undertake its new trading structure.

Given the variety of trading patterns possible under prior law, the tax aspects of the push-out rule should be considered under a number of different scenarios. It can involve moving both trading personnel and the trading books, moving people only, or moving the trading books only. Also, because the Act's provision permits existing positions to remain in a banking entity, institutions may decide to move a trading book by moving the personnel involved in trading off it to a new entity and booking new positions in that entity on a prospective basis, leaving the historical positions behind.

Attached to this Introduction is a chart (Appendix B) that outlines a good number of the permutations that are possible in complying with the push-out rule. The discussion below first addresses a few of the major tax issues that may arise for the bank pushing out swaps, focusing initially on the assets that may be transferred as part of the push-out rule.

Since trading positions are typically marked to market for tax purposes by swaps dealers, the likely focus will be on whether any intangibles of value have been transferred out of the bank. In the case of potentially taxable transactions, if all that is being transferred is a workforce, taxpayers may argue that no recognizable intangible has been transferred. Generally, the casual movement of one trader or a small group of traders and sales personnel should not constitute a taxable event.25 The same argument might be made for the transfer of even large groups of employees.

However, if a sizable group of employees is being reassigned, IRC section 197(d)(1)(C)(i) recognizes a "workforce in place" as an identifiable intangible for purposes of section 197 irrespective of whether the employees are covered by employment contracts. Further, workforce is considered to be a part of the "platform" intangible under the temporary cost sharing regulations in Treas. Reg. section 1.482-7T. It is also the subject of recent legislative proposals.26

If the swaps trading book is being moved, there may be an issue as to whether a customer based intangible has been transferred. While the courts have found customer lists to be identifiable intangibles for tax purposes,27 the customer base of most swaps dealers probably will have little value since it will consist mainly of large corporate customers and other banks. These counterparties have little loyalty to a given financial institution, and, therefore, there is little assurance that they will be a ready source of future profits.

In the past, the IRS has argued that certain transactions involve the transfer of a valuable "business opportunity" intangible. However, the mere movement of future trading activity on a prospective basis should not by itself constitute a taxable transfer of a business opportunity.28

The movement of an entire business (trading personnel and positions) may involve the transfer of goodwill and going concern value. When the transfer of an entire business is involved, the analysis should start with the view that there may be a potential tax realization event. The first order of business will then be to determine whether the business has a fair market value beyond the tax basis of the transferred assets. The taxpayer can then sort out whether any identifiable intangibles have been transferred or only goodwill and going concern were involved.

A potentially taxable transfer must then be put into context. If it involves the transfer between entities in a consolidated or controlled group of corporations, any gains or losses will likely be deferred.29 If it occurs between controlled foreign corporations, there likely will be no recognition of Subpart F income if the transferor entity is involved in the conduct of an active trade or business.30

We turn now to the impact of the push-out rule on the assignee non-bank affiliate and on customers of the bank.

If swaps in the bank are novated and the existing swap position is assumed by a non-bank affiliate, the assignment of the swap may trigger a taxable event to the bank's customer (the non-assigning counterparty). Under the general principles in IRC section 1001, the substitution of a new counterparty probably will constitute a taxable event. There is an exception to the general rule, but the exception may only apply in limited circumstances.31 Unless this exception applies, customers will likely realize gain or loss equal to the fair market value of the derivative at the time of the novation and must take that gain or loss into account under applicable tax principles.

In a novation, the bank or the non-bank affiliate will often need to make a payment to account for the difference between current market rates and the rates reflected in the existing swap. For the bank, this payment will be a termination payment and for swaps marked to market should only trigger additional gain or loss to the extent of changes since the end of the last taxable year. The non-bank affiliate assuming the swap will typically be a swaps dealer. To it, the payment will move the swap position onto its balance sheet and be treated as a non-periodic payment.32

Bank Capital and Liquidity

The Act establishes new rules in this area. Equally important, under Basel III, new capital guidelines have also recently been set.

The Act's Provisions

Under the "Collins Amendment," the Act imposes risk-based and leverage-capital standards currently applicable to U.S. banks on U.S. bank holding companies and on nonbank financial companies supervised by the Federal Reserve. These rules will also be applied to U.S. bank holding company subsidiaries of foreign banking institutions. In a major change from current law, the new rules exclude trust preferred securities from the Tier 1 regulatory capital of bank holding companies.33 The Act's provisions set a floor for the capital required by bank and nonbank financial holding companies. To the degree the Basel III standards are more stringent, its standards presumably will apply.

Basel III Provisions

Beginning late in 2010, the Basel Committee began issuing the Basel III set of rules dealing with bank regulation and bank capital requirements (collectively, Basel III).

Under Basel III, the minimum common share equity requirements will rise from 2% to 4.5% of risk adjusted assets, total Tier 1 equity must be at least 6% (includes common share equity and certain other Tier 1 qualifying instruments), and total capital (Tier 1 and Tier 2) must be at least 8%. A new requirement for a capital conservation buffer of common share equity of at least 2.5% of risk adjusted assets will be imposed. Also, an additional countercyclical buffer of anywhere from nil to 2.5% of risk adjusted assets will be implemented by local jurisdictions to protect the banking sector from periods of excess credit growth. The purpose of this buffer, to be built-up during good times, is to provide needed capital during periods of financial distress. Finally, the Basel III rules tighten somewhat the recognition of deferred tax assets for bank regulatory capital purposes over what they had previously been in the United States.

Contingent Capital

The Act authorizes the Federal Reserve to require bank and nonfinancial holding companies "to maintain a minimum amount of contingent capital that is convertible to equity in times of financial stress."34 In August 2010, the Basel Committee issued a consultative document recommending that financial instruments issued by internationally active banks giving rise to Tier 1 or Tier 2 capital contain a provision that, at the option of the relevant banking authority, the instrument could be written off or converted into common equity upon the occurrence of certain trigger events.35 The trigger events basically were the conclusion of the regulators that the future operations of the bank had become "non-viable." On January 13, 2011, the Basel Committee formalized this requirement.36 Accordingly, future financial instruments will need to contain a provision meeting the new requirement unless the governing jurisdiction in question has a law giving banking authorities the power to undertake the same measures irrespective of whether the instruments themselves contain such a provision.

Timing

The implementation dates of the above provisions are complicated. For U.S. institutions, the Collins Amendment will generally be phased in incrementally from January 1, 2013 to January 1, 2016. Foreign institutions with U.S. Bank Holdcos will have five years after the date of enactment of the Act to make needed changes to the capital of their U.S. Holdcos.

Generally, the Basel III rules will be phased in between January 1, 2013 and January 1, 2018. Member countries must translate the new rules into national laws and regulations before 2013. With respect to the contingent capital requirements, the new rules apply to instruments issued after January 1, 2013. Instruments issued prior to that date will be phased out as meeting an institution's capital requirements over a period of 10 years.

Tax Issues

The paradigm for the Act's call for and Basel III's requirement for contingent capital probably will be contingent convertible bonds (CoCos). CoCos have already been issued by several European banks. Two of these instruments (which are in a form more likely to be followed by other institutions) are discussed below.

The first instrument is a subordinated note that will automatically be converted into common equity in the event the bank's consolidated core Tier 1 capital ratio decreases to less than 5% (at issuance, it was about 8.6%). The conversion price was set at approximately 65% of the current market trading price of the common shares at their date of issuance. This conversion price was designed to give the holders somewhat of a lesser loss, assuming the conversion was generated by the bank's poor financial performance and the stock declined as a result of this performance.

The other instruments were issued out of a special purpose entity established in Guernsey with a subordinated guarantee from the parent company. They constitute "Buffer Capital Notes," are subordinated debt and have a term of 30 years. In the event the common equity Tier 1 ratio of the bank holding company (or the core Tier 1 ratio prior to Basel III implementation) falls below 7% (at issuance, the core Tier 1 ratio was about 12%) or the bank holding company essentially becomes "non-viable" (within the meaning of the Basel notice on contingent capital), the notes automatically convert into the common equity of the parent company. The conversion price is the current market price of the shares, subject to a floor set at approximately 50% of the current market trading price of the common shares at their date of issuance. Based on the conversion ratio, if the market price is at or above the floor, the holders will receive shares equal to the full principal amount of their investment, but if it is below the floor, they will suffer a loss equal to the difference between the floor and the lower market value.

Debt versus equity -- The examination of the debt versus equity issue typically covers a list of enumerated qualities, each of which is examined in determining whether a particular instrument should be treated as debt or equity.37 The one distinguishing feature of CoCos has to do with their treatment in the event that the issuer suffers a capital deficiency (or, under the Basel provision, becomes non-viable).

In Rev. Rul. 83-98,38 the IRS concluded that notes payable at maturity in a predetermined number of shares of stock must be treated as equity for tax purposes. By contrast, in Rev. Rul. 85-119,39 the IRS found that debt that would be retired at maturity either with shares of stock then equal in value to the principal amount of the debt or with the proceeds from the sale of stock yielding an amount sufficient to retire the full amount of the debt, constituted true debt for tax purposes.

The touchstone of these rulings is that the holder of the debt instrument cannot be put at risk for the fortunes of the issuer with respect to the recovery of its investment. Put differently, there must be a sum certain to retire the debt investment in order for the instrument to be treated as debt for tax purposes. This sum certain cannot exist if it is pegged to a set amount of stock whose future value cannot be determined at the issuance date.

The first type of CoCos certainly puts the holder at risk on the payment of the debt instrument. This risk is, however, contingent on the capital position of the issuing bank, and, absent a significant deterioration in this position, the instrument will be paid in full at maturity. The second type of CoCos faces a similar risk.

A line of cases dealing with "surplus capital notes" issued by insurance companies to meet regulatory requirements offers some support for treating CoCos as debt. In these cases, the interest and principal on the notes could only be paid out of "surplus" capital. Hence, their repayment was contingent on the ability of the company basically to make payments out of earnings. Nevertheless, these notes were found to constitute debt for tax purposes with the courts relying heavily on the fact that the notes were likely to be paid and that their form was dictated by insurance regulations.40

Conventional convertible debt that will be converted into equity at the holder's option is typically viewed as debt for tax purposes, provided the conversion feature is not in-the-money at the time of issuance. In the case of the recent issuances of CoCos, the conversion feature is triggered by the worsening condition of the bank. This is a cause for greater concern.41 Ultimately, the treatment of this type of CoCos probably will depend on how likely it is that the equity contingency will be exercised. The debt versus equity issue probably will not be resolved until the U.S. tax authorities address it.

Assuming the CoCos are treated as debt instruments for purposes of the U.S. tax law, IRC section 163(l) provides that no deduction will be allowed for interest paid on a "disqualified debt instrument." This provision only affects issuers of debt, not debt holders.

A disqualified debt instrument is defined as one where:

 

(A) a substantial amount of the principal or interest is required to be paid or converted, or at the option of the issuer . . . is payable in, or convertible into [the equity of the issuer],

(B) a substantial amount of the principal or interest is required to be determined, or at the option of the issuer . . . is determined, by reference to the value of such equity, or

(C) the indebtedness is part of an arrangement which is reasonably expected to result in a transaction described [above].

 

Neither the statute nor the legislative history relating to IRC section 163(l) addresses contingent convertible bond type instruments.42 Rather, the section was directed at instruments then being issued in the market that mandatorily were convertible into equity at maturity or could be converted into equity at the option of the issuer. In the present case, the instruments are not mandatorily convertible into equity. Indeed, the issuer does not expect them to be converted into equity, and the issuer has no option to convert them into equity. Hence, their treatment may turn on the view of whether clause (C), above, applies to them. This is a gray area and one probably incapable of exacting determination except, again, with the guidance of the U.S. tax authorities.

Securitization

The Act's Provisions

The Act imposes new risk retention requirements on "securitizers" (issuers of asset backed securities (ABS) or the person who initiates the asset backed transaction (the "sponsor")).43 In general, except for asset pools consisting entirely of "qualified residential mortgages" or other qualifying exempt assets, a securitizer must retain a minimum of 5% of the credit risk in the assets it sells into a securitization. Securitizers can reduce their risk if adequately capitalized third party purchasers or "originators" of the securitized assets assume a commensurate amount of risk.

On March 28, 2011, a number of Federal agencies released a joint notice of proposed rulemaking containing proposed rules to implement the risk retention provisions of the Act (the Proposed Rules).44 The Proposed Rules can be broken into two sections, the first dealing with permissible forms of risk retention and the second dealing with exemptions from the risk retention requirements (RRR).

The Proposed Rules set out seven different methods of satisfying the risk retention requirements of the Act. Briefly, the seven methods are:

 

1. Vertical risk retention -- The sponsor may satisfy the RRR by retaining at least a 5% interest in each class of asset backed securities;

2. Horizontal risk retention -- The sponsor may satisfy the RRR by maintaining a horizontal residual interest (i.e., the first loss tranche in a securitization transaction) at least equal to 5% of the par value of the asset backed securities;

3. B piece buyer for commercial mortgage backed securities -- A qualified third party buyer may satisfy the RRR by buying the junior subordinated interest (the B piece) in a commercial mortgage backed securitization at least equal to 5% of the par value of the commercial mortgages;

4. L shaped risk retention -- The sponsor may satisfy the RRR by retaining vertical and horizontal risk retention components each of which is at least equal to 2.5% of the asset backed securities;

5. Revolving asset master trusts -- The sponsor may satisfy the RRR in a revolving asset master trust (securitization vehicles for credit cards) by maintaining a "seller's interest" in not less than 5% of the unpaid principal balances of the revolving assets in the trust;

6. Representative sample -- The sponsor may satisfy the RRR by retaining a randomly selected sample of the assets equal to not less than 5% of the principal balance of assets involved in a securitization; and

7. Asset backed commercial paper (ABCP) conduits -- A sponsor of a qualified ABCP conduit may satisfy the RRR if each originator that transfers assets to the conduit retains an eligible horizontal interest in the special purpose vehicle it established to issue interests to the ABCP conduit.

 

In addition to the 5% requirement just described, the Proposed Rules impose a separate requirement that the sponsor must establish and fund a "premium capture reserve account" in a securitization when the sponsor has received a premium (as defined in the Proposed Rules) from the sale of the ABS. Amounts in the premium capture reserve account are required to be used to satisfy payments on the ABS prior to the allocation of losses to any other interest in the issuer (including any interests retained under the RRR).

As for assets eligible to be exempted from the risk retention requirements, the Proposed Rules spell out in some detail the credit requirements that need to be satisfied in order for (i) qualified residential mortgages, and (ii) securities backed by qualifying commercial, commercial real estate, and automobile loans to be exempted from the requirements.

The Proposed Rules also set forth the rules prohibiting hedging of retained interests in the ABS and deal with the effect of the involvement of government sponsored entities on the risk retention requirements.

Timing

The provisions in the Act come into force within one year after implementing regulations have been published in final form for residential mortgages and within two years after regulations have been published in final form for all other asset classes. The regulations are required to be issued within 270 days of enactment of the Act.

Tax Issues

In general, the main tax issues relating to securitizations are:

  • Will the securitization result in a sale of the securitized assets by the originator of the assets or in a borrowing secured by these assets?

  • What will be the character of the issuing entity (i.e., will it be a separately taxable entity, a flow thru entity or totally disregarded)?

  • How will the securities be taxed in the hands of the holders (i.e., as debt, equity or an undivided interest in the underlying assets)?

 

A detailed examination of the impact of the Act's risk retention requirements (as amplified by the Proposed Rules) on these issues is beyond the scope of this Introduction. It should be noted that, even before the Act, many securitizers retained some portion of asset risk in their securitization programs, either through continued ownership of the assets or through retention of subordinated classes of securities issued by the securitization vehicle. In these cases, the Act may result in changes more of degree than of kind (5% equity instead of 2% or 3%). However, depending on the circumstances, the risk retention requirements may raise questions about REMIC qualification, may cause disregarded entities to become regarded entities for tax purposes, may create uncertainty around the characterization of interests as debt or equity, and may put pressure on whether certain structures are treated as taxable mortgage pools.

Executive Compensation and Corporate Governance

The Act contains a number of provisions relating to executive compensation and corporate governance. The discussion below highlights the most important of these items and considers related tax provisions.45

Shareholder Approvals and Disclosures

The Act's Provisions

Shareholder approval of executive compensation ("say on pay")46 -- At least once every three years, the Act requires a resolution to be included in the issuer's proxy statement on which shareholders must have a non-binding vote to approve the compensation of executives. While these votes are nonbinding, companies must address whether and how they considered the shareholder votes and how the votes affected executive compensation policies and decisions. In addition, at least every six years, shareholders must vote on a separate resolution with respect to whether this vote must occur every one, two or three years (and most are now trending to one year). Non-binding votes to approve executive compensation are already required for companies receiving assistance under the Troubled Asset Relief Program. The new requirement now applies to all publicly traded companies with respect to the compensation of executives required to be disclosed pursuant to the SEC rules.

Shareholder approval of golden parachutes47 -- The issuer's proxy statement must disclose any agreements with certain executive officers (currently the chief executive officer and the three most highly paid officers) that concern any compensation that is based on an acquisition, merger, consolidation, sale, or other disposition of substantially all of the assets of the issuer unless already disclosed and voted under the say on pay provision. This disclosure must include the aggregate total of any such compensation and any related conditions attached to the payment. In addition, a resolution with this information must be included in the proxy, and shareholders must have a non-binding vote to approve such compensation.

Disclosure of executive pay versus performance -- The proxy statement must disclose the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account changes in share value and dividends and other distributions. In addition, the issuer must disclose the median of the annual total compensation of all of the issuer's employees other than the chief executive officer, the annual total compensation of the chief executive officer, and the ratio of these amounts.

Disclosure of employee and director hedging -- The proxy statement must disclose whether any employee or member of the board is permitted under company policy to purchase financial instruments designed to hedge any decrease in the market value of securities that are paid in compensation or otherwise held by such individuals. These instruments include prepaid variable forward contracts, equity swaps, collars, and exchange funds.

Timing

The say on pay provision and the golden parachute provisions are effective at a company's first shareholder meeting or proxy solicitation occurring after January 21, 2011. The effective date of the pay versus performance and the hedging provisions will be contained in rules the SEC intends to issue by mid-year 2011.

Tax Issues

The new rules in the Act dealing with executive compensation revisit areas that Congress has already touched on in the tax law. IRC section 162(m) generally disallows a public company from deducting compensation that is paid to each named executive officer in excess of one million dollars per taxable year. However, an exemption from this disallowance provision applies to certain performance-based compensation that is subject to performance goals that must be established by a compensation committee comprised of at least two "outside directors". IRC section 280G provides an intricate set of rules that if violated disallow a deduction for "excess parachute payments" made to executives in connection with the change in ownership or control of a corporation or a substantial portion of its assets. The Act's provisions supplement these provisions by requiring public disclosure of much of the information needed to apply the tax provisions.

Recovery of Compensation Determined to be Excessive

The Act's Provision

The SEC is required to prohibit the listing of securities of an issuer that does not develop and implement a policy that provides for (i) disclosure of the issuer's policy on incentive-based compensation based on financial information required to be reported under securities laws, and (ii) recovery of incentive-based compensation from current or former executive officers that is determined to be in excess of what should have been paid, based on revised figures in an accounting restatement. This applies to compensation paid during the three year period preceding the date of any accounting restatement. In addition, proposed multi-agency guidance provides that, at least for large firms, 50% of any bonus must be deferred for at least three years and may be cut back for losses incurred by the company during the deferral period.48

Timing

The effective date of the clawback provision will be contained in rules the SEC intends to issue by mid-year 2011. The bonus deferral rule is proposed to be effective six months after it is finalized.

Tax Issues

To the extent that amounts paid by the issuer are subject to reporting and wage withholding in one year and subsequently required to be paid back in a following year by the executive, there is no relief or adjustment available for the wage withholding and reporting in the prior year of payment. Rather, any claim of loss becomes an individual tax issue of the executive to deal with under the tax law, perhaps under an IRC section 1341 "claim of right" theory. The Act does not appear to prohibit indemnifying the executive for any such loss, but any such indemnification payment will be considered compensation subject to reporting and wage withholding.

Independence

The Act's Provisions49

Independence of members of compensation committee -- For any company with equity securities listed on a national securities exchange or a national securities association, all members of the company's compensation committee must be independent members of the issuer's board of directors. For this purpose, determination of the member's independence takes into account the source of the member's compensation including any consulting, advisory, or other fee paid by the issuer to the member, and whether the member is affiliated with the issuer.

Independence of compensation consultants and advisors -- The Act sets forth the factors an issuer's compensation committee must consider in selecting a compensation consultant or advisor to ensure their independence. These factors include other services provided to the person, the amount of fees paid to them by the issuer, any stock of the issuer owned by the person, any relationships between these individuals with any member of the compensation committee, and the policies and procedures of the employer of the person designed to prevent conflicts of interest. The compensation committee is responsible for the appointment, compensation, and oversight of its compensation advisors. In addition, the issuer must disclose in its proxy statement any compensation consultants that are retained by it, whether their work raised any conflict of interest, and if so, the nature of the conflict and how it is being addressed.

Tax Issue

The regulations and guidance regarding outside directors for purposes of IRC section 162(m) dealing with excessive employee compensation should be considered for tax purposes separately from the rules regarding whether compensation committee members are independent for purposes of the Act. Although the provisions in the Act still await clarification from the SEC, the two sets of rules ultimately may not match.

Conclusion

The Act is the most comprehensive piece of legislation impacting financial institutions since the legislation enacted in the 1930s during the Great Depression. The Act will have far reaching effects, many of which will result in significant tax consequences. Financial institutions must carefully assess the potential tax implications of approaches to complying with the Act in order to manage effectively their tax position, and should continue to monitor changes in the regulatory landscape and the tax issues that arise from those changes.

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG 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.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

 

FOOTNOTES

 

 

1 Pub. L. No. 111-203, enacted on July 21, 2010. All "section" references are to the Act, unless otherwise indicated. For clarity, references to the Internal Revenue Code of 1986, as amended, are denoted "IRC," and references to Treasury tax regulations are denoted "Treas. Reg." A number of Federal agencies have issued rules and proposed rules under the Act. The most pertinent of these are cited herein. Citations are current through April 2011.

2 The Basel Committee on Banking Supervision (the Basel Committee) consists of senior representatives of bank supervisory authorities and central banks from about 30 countries. It usually meets at the Bank for International Settlements (BIS) in Basel, Switzerland, where its permanent Secretariat is located. In December 2010, the Basel Committee issued rules entitled "Basel III: A global regulatory framework for more resilient banks and banking systems" (Basel III rules).

3 The Act contains two provisions relating to living wills. Sections 165(b)(1)(A)(iv) and (d)(1) specifically require covered institutions to prepare resolution plans. Section 166 requires regulators to adopt rules dealing with the early remediation steps regulators should take with troubled institutions. We expect living wills will include both recovery plans (dealing with the remediation provision in the Act) and resolution plans (dealing with the resolution provision in the Act). On March 29, 2011, the FDIC and the Federal Reserve jointly issued proposed rules designed to implement the provisions of Section 165(d).

4 In January 2011, the Financial Stability Oversight Council (FSOC) issued guidance on what items to consider in determining whether a non-bank financial firm was systemically important so as to be covered by the prudential rules set out in the Act. FSOC, AUTHORITY TO REQUIRE SUPERVISION AND REGULATION OF CERTAIN NONBANK FINANCIAL COMPANIES (Jan. 2011).

5See, e.g., IRC §§ 267, 311(b), 382, 383, 384, 1121.

6See IRC § 367.

7 Treas. Reg. § 1.1502-13.

8 Treas. Reg. § 1.1502-19.

9 Treas. Reg. §§ 1.1502-35, -36.

10 Treas. Reg. § 1.1502-13.

11 IRC § 267.

12See, e.g., IRC § 108; Treas. Reg. § 1.1001-3.

13See, e.g., Treas. Reg. § 1.1001-3.

14 Section 619. The FSOC has issued preliminary guidance on how the Volcker Rule should be formulated by the agencies having direct regulatory authority over financial institutions covered by the Act. FSOC, STUDY & RECOMMENDATIONS ON PROHIBITIONS ON PROPRIETY TRADING & CERTAIN RELATIONSHIPS WITH HEDGE FUNDS & PRIVATE EQUITY FUNDS (Jan. 2011).

15 Commodity Futures Trading Commission (CFTC).

16 Part II of Title VII (Wall Street Transparency and Accountability) of the Act covers the regulation of swap markets. Section 723 is the major section dealing with the clearing and trading of swaps. Sections 727, 728 and 729 are the major sections dealing with reporting of swaps transactions.

17 Section 716. This section creates the prohibition in a circular fashion by denying FDIC insurance to banks engaging in impermissible swaps dealing. Almost all banks are required to have FDIC insurance.

18 The exact reach of the Act on foreign exchange swaps is unclear, but the reporting requirements of the Act should apply to them.

19 Section 716(b)(D). It is unclear what is meant by "tax breaks" in this provision.

20 Edge Act subsidiaries are foreign corporations owned by a bank subsidiary that acts as a holding company (an "Edge Act" company) for these foreign companies. The foreign subsidiaries are authorized under section 25A of the Federal Reserve Act to engage in a broad set of banking activities overseas. The extra-territorial reach of the Act to such subsidiaries is unclear.

21See the discussion of the scope of IRC section 1256 in Tax Notes Today, IRS May Restrict Definition of Swap to Notional Principal Contracts, 2010 TNT 240-3 2010 TNT 240-3: News Stories (Dec. 15, 2010).

22See DAVID LOADER, CLEARING, SETTLEMENT AND CUSTODY, ch. 5 (Derivatives clearing and settlement) (Butterworth Heinemann 2002), for a discussion of clearing of derivatives.

23 Treas. Reg. § 1.446-3(g)(4).

24 IRC §§ 881(c)(1), (c)(3)(B).

25 Treas. Reg. section 1.482-4(b) provides that the ". . . services of any individual . . ." by themselves do not constitute a valuable intangible. There is also case law support for the position that workforce in place is not a discrete intangible asset for U.S. tax purposes. Hospital Corp. of America v. Comm'r., 81 T.C. 520 (1983), nonacq., 1987-2 C.B. 1; Ithaca Industries v. Comm'r., 97 T.C. 253, 271 (1991), aff'd, 17 F.3d 684 (4th Cir. 1994). But see Newark Morning Ledger Co. v. U.S., 507 U.S. 546 (1993).

26See JOINT COMM. ON TAX'N, JCS-4-09, DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT'S FISCAL YEAR 2010 BUDGET PROPOSAL, PART THREE: PROVISIONS RELATED TO THE TAXATION OF CROSS-BORDER INCOME AND INVESTMENT, 28-55 (Sept. 14, 2009).

27See e.g., Newark Morning Ledger, 507 U.S. 546.

28 The mere transfer of a trading business opportunity should not constitute a taxable transfer of property where the transferor will play no role in the creation of new positions, and the transferee entity's capital will be deployed to absorb the risk of the new positions. See Hospital Corp. of America, 81 T.C. 520.

29 Treas. Reg. § 1.1502-13; IRC § 267(f). The deferral provisions in the federal law may not apply for state and local income tax purposes.

30 Under the Subpart F rules, the transferring CFC should not suffer an immediate tax on the transfer of IRC section 954(h) property assuming it qualifies for the active financing exception under sections 954(c)(2)(C) and/or (h). IRC § 954(c)(1)(B). Further, Treas. Reg. sections 1.954-2(e)(1) and (3) generally should provide protection from foreign personal holding company income treatment for gains from the sale of dealer property and intangible assets (including goodwill and going concern), respectively, used in an active trade or business. The sale may not trigger foreign base company sales income because the property involved may be either (i) treated as sold for use in the country of the CFC seller's incorporation or (ii) treated as created in the country where the CFC is located.

31 Treas. Reg. section 1.1001-4 sets out an exception to taxable treatment of a novation of certain derivatives where the assignor and the assignee of a notional principal contract are both dealers and the contract permits the substitution.

32 Treas. Reg. section 1.446-3(h) provides for the treatment of termination payments of notional principal contracts. The notional principal regulations do not directly provide for the treatment of payments to or by an assuming swaps dealer that marks its swaps to market. The payment economically will put them into the same position as if they had entered into the swap initially and posted collateral equal to the fair market value of the swap. It may be reasonable to treat the nonperiodic payment as simply establishing the derivative's position on the non-bank affiliate's books. See generally Treas. Reg. §§ 1.446-3(f), (g)(4), (h)(3) (treatment of assuming party).

33 Section 171. The Act bars holding companies from using trust preferred indirectly. It imposes on holding companies the capital standards set for regulated banks, and regulated banks cannot utilize trust preferred securities in their capital. The provisions in the Act appear to leave in place the present treatment of certain REIT preferred as giving rise to good Tier I capital when issued by a bank.

34 Section 165(c).

35 BASEL COMMITTEE, PROPOSAL TO INSURE THE LOSS ABSORBENCY OF REGULATORY CAPITAL AT THE POINT OF NON-VIABILITY (Aug. 2010).

36 BASEL COMMITTEE, MINIMUM REQUIREMENTS TO ENSURE LOSS ABSORBENCY AT THE POINT OF NON-VIABILITY (Jan. 13, 2011).

37 The enumerated items typically include (i) the name given the instrument, (ii) a fixed or determinable maturity date, (iii) remedies on default, (iv) subordination, (v) nature of the return on the instrument (dividend or interest in character), (vi) participation in the issuer's gains or losses, and (vii) participation in corporate management. See, e.g., Notice 94-47, 1994-1 C.B. 357; CCA 200932049 (Mar. 10, 2009).

38 1983-2 C.B. 40.

39 1985-2 C.B. 60.

40See, e.g., Jones v. U.S., 659 F.2d 618 (5th Cir. 1981); Anchor Nat'l Life Ins. Co. v. Comm'r., 93 T.C. 34 (1989).

41See BITKER & EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS, § 4.03[2] [f] and [g] and the authorities cited therein.

42See JOINT COMM. ON TAX'N, JCS-23-97, GENERAL EXPLANATION OF TAX LEGISLATION ENACTED IN1997, at 192-193 (Dec. 17, 1997).

43 Section 941(b).

44 The Proposed Rules were jointly issued by the federal banking regulators, the SEC, the Department of Housing and Urban Development, and the Federal Housing Finance Agency.

45 Subtitles E and G of Title IX of the Act contain the sections dealing with corporate governance and executive compensation.

46 On April 4, 2011, the SEC issued a final rule dealing with the "say on pay provision". See SEC Rule 14a-21.

47 On April 4, 2011, as part of the "say on pay" rules that were issued, the SEC also addressed the golden parachute provisions of the Act.

48See, e.g., 12 C.F.R. § 42.5(b)(3) (proposed rule) (Mar. 2, 2011).

49 On March 30, 2011, the SEC issued proposed rules dealing with the different independence provisions of the Act.

 

END OF FOOTNOTES

 

 

* * * * *

 

 

Appendix A

 

 

Living Wills & The Volcker Rule -- Tax Issues List

 

 

The following highlights various tax issues that should be considered in connection with disposition and internal restructuring transactions and other matters surrounding the preparation of a living will or the Volcker Rule. While this list focuses on federal income tax matters, foreign, state and local tax issues also should be considered. This list is for general information only, is not exhaustive, and is not a substitute for careful, individualized tax advice and analysis.

Planning for Dispositions

 

1. Will the disposition be structured as an asset or stock sale (or perhaps in some other manner, such as a contribution of assets to a new joint venture)?

2. Is accurate tax basis and tax attribute information available?

3. Will pre-transaction restructuring be needed (for example, transferring assets and personnel to a new entity)?

4. Will transfers of personnel have any employment tax or other tax ramifications?

5. Is the disposition expected to result in gain or loss, and should the transaction be structured to be taxable or tax-free?

6. How will the transfer or assumption of contingent assets or liabilities in the transaction affect the tax consequences?

7. If intercompany debt or other interrelationships need to be severed in connection with the disposition, what tax consequences will result from those steps?

8. If a tax-free spin-off is desired, will all of the requirements under IRC section 355 be satisfied?1 Have the limitations on pre- and post-spin acquisitions under IRC sections 355(d) and (e) been fully considered?

9. Will the transaction trigger the recapture of tax credits, overall foreign losses, or other items?2

10. If a controlled foreign corporation is involved, will gain be triggered under a gain recognition agreement (or, under appropriate facts, might gain recognition be deferred by entering into a gain recognition agreement)?3

11. Will recognition of deferred intercompany items or excess loss accounts be triggered?4

12. Will the unified loss rule, or other limitations on the recognition or utilization of losses, be brought into play?5

13. Can transactions be structured or timed in such a fashion as to increase the utilization of (and/or decrease any limitations on) net operating losses and other tax attributes?6

14. How will net operating losses and other tax attributes (and any IRC section 382 limitation amounts) be allocated between sold and retained entities?

15. If a joint venture or partnership is involved, have the relevant partnership tax provisions been considered (including, for example, the rules pertaining to "hot assets," IRC section 704(c) property, and technical terminations)?7

16. Will the disposition cause a "signification modification" to third party or related party debt, generating cancellation of indebtedness income or other tax consequences?8

17. Will the disposition cause an actual or deemed exchange of derivative positions (or other financial instruments) to one or both counterparties?9

18. Will significant transfer taxes be incurred?

 

Internal Restructuring and Capital Raising Transactions (in addition to the above issues)

 

1. How will new instruments issued to raise capital be characterized for tax purposes? Will interest be deductible?

2. Will the raising of new capital create issues regarding a change of ownership under IRC section 382, impact tax attribute utilization or raise concerns about the "antistuffing" rules?10

3. Will the transfer of businesses or assets between members of a consolidated group generate deferred intercompany items?11

4. Will items that are deferred for federal income tax purposes have immediate state or local tax consequences?12

5. Could restructuring transactions (individually or together with other transactions) be recharacterized for income tax purposes in various, and possibly overlapping, ways so as to have different tax consequences than intended?13

6. If assets are transferred for consideration that is more or less than the assets' fair market value (for example, for "book value"), could deemed dividends or contributions, or other recharacterizations apply?

7. In a cross-chain sale of assets, could unintended tax consequences arise due to the potential issuance of a "nominal share" of acquirer stock under the "stockless D" reorganization regulations?14

8. In a taxable transaction, what assets (including goodwill and other intangible assets) will receive a stepped-up basis for tax purposes, and will the potential step-up be caught by the "anti-churning" rules?15

9. On loss transactions, will IRC section 267 defer or deny the use of any losses?

10. For transactions involving controlled foreign corporations, will the transactions create Subpart F income?16

11. Will foreign transactions be treated as "covered asset acquisitions" or be subject to the "splitter rules"?17

12. Could the intended tax-free treatment of a reorganization, liquidation or contribution be jeopardized by the questionable solvency of an entity?18

13. Could the potential recharacterization of intercompany debt as equity alter the intended tax classification of an entity or the intended tax consequences of a restructuring transaction?

14. If an entity is insolvent, when and how should a worthless stock deduction be claimed, and can planning be undertaken to take the loss as an ordinary loss?19

15. If intercompany debt is partially or wholly worthless, what loss on the debt can be claimed?20

16. If distressed financial assets are being sold, how should the buying entity treat the "market discount" arising on the sale?21

 

Other considerations related to dispositions, Internal restructuring Transactions and living Wills Generally

 

1. Will customers recognize gain or loss on derivative positions that are novated in a restructuring and will the restructuring give rise to changes in withholding tax rates on financial instruments or raise other tax issues?22

2. Will restructuring change the tax residence or nexus of a company for state and local tax purposes?23

3. Will restructuring give rise to a new permanent establishment off-shore, or otherwise impact tax treaty positions?24

4. Will the movement of assets or entire business units shift the entities in which certain important functions are performed, necessitating changes in existing transfer pricing policies and service level agreements?25

5. Will changes in the business profile of an entity caused by a restructuring generate a change in the analysis or exposure related to outstanding tax controversies or uncertain tax positions?

6. If assets are moved or disposed of, what will be the impact on hedging positions?26

7. For transactions affecting controlled foreign corporations having a functional currency other than the U.S. dollar, will the transaction generate a foreign currency gain or loss?27

8. What will be the impact on GAAP accounting for income taxes of any disposition of a business or the movement of assets; in particular, will the change affect an APB 23 assertion made by a foreign subsidiary?28

9. Will the change in how a business or entity is structured trigger or require a change in accounting method?

10. When inventorying legal entities for the living will, has the company's organization chart been reviewed and updated, and has the tax department been apprised of all changes?

11. If the tax department chooses to conduct a general tax planning review when reviewing the organization chart and living will, are there stale tax planning structures that should be removed, or new tax planning opportunities that could be implemented?

12. Are there opportunities for eliminating or consolidating entities, in isolated circumstances or as part of a full-scale legal entity rationalization project?

13. Are any valuations or tax studies needed (including, for example, basis studies, earnings and profits studies, or IRC section 382 ownership change and NUBIL/NUBIG determinations)?

14. When looking at the interrelationships among entities in the group, are intercompany debt and other related party transactions properly documented, and are transfer pricing policies up to date?

15. Does the organization need to implement or update any tax allocation agreements?

 

Establishing New Hedge Funds and Private Equity Funds29

1. What form should the new fund take:

  • Will a new hedge fund take the common form of a master-feeder structure with a master fund established off-shore and treated as a partnership for U.S. tax purposes, a domestic feeder LLC for U.S. investors, and a foreign corporation for non-U.S. and tax-exempt investors?

  • For private equity funds, is a simpler Delaware limited partnership structure to be established?

  • 2. What taxable year and accounting methods should be elected by the new fund?

    3. Will a new hedge fund elect "trader" status under IRC section 475(f)?

    4. How will the partners' distributive share of income, gain, loss, deductions and credits be allocated so as to give them substantial economic effect?

    5. Will the partnership make a "reverse 704(c) election" in order to allow historical partners who have terminated their investments to realize their share of unrealized appreciation or depreciation once these amounts have be realized?

    6. Will the partnership make an IRC section 754 election to account for retired and new investors in the fund? How will the decision on making a "trader" election affect the IRC section 754 election?

    7. How will the fund managers be compensated? Should they be given "carried" interests?

    8. How should the fund deal with the rules in IRC section 409A dealing with deferred compensation under nonqualified deferred compensation plans?

    9. How will the fund deal with withholding taxes on investments made by foreign investors?

    10. How will the fund handle information reporting and the FATCA requirements?

 

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG 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.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

 

FOOTNOTES TO APPENDIX A

 

 

1See generally Tom Wessel, Joseph Pari & Richard D'Avino, Corporate Distributions Under Section 355, in THE CORPORATE TAX PRACTICE SERIES: STRATEGIES FOR ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS (PLI 2009).

2See, e.g., IRC §§ 42(j) (low-income housing credit), 45D(g) (new markets credit), 48(d)(2) (energy credit). See also IRC §§ 904(f), 1245, 1250.

3 Treas. Reg. §§ 1.367(a)-3(b) through (e), 1.367(a)-8.

4 Treas. Reg. §§ 1.1502-13, 1.1502-19.

5 Treas. Reg. § 1.1502-36. See also IRC §§ 382(h)(1)(B), 383, 384, 1121.

6See generally Thomas Avent, Jr. & John Simon, Preserving Tax Benefits in Troubled Companies -- Navigating Mostly Unchartered Waters, in THE CORPORATE TAX PRACTICE SERIES: STRATEGIES FOR ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS (PLI 2009); Deanna Walton Harris & Mark Hoffenberg, Be Careful What You Wish For: Is Section 382's Treasure Section 384's Trash?, in THE CORPORATE TAX PRACTICE SERIES: STRATEGIES FOR ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS (PLI 2009).

7See, e.g., IRC §§ 704, 707, 708, 751. See generally MCKEE, NELSON, & WHITMORE, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS, ch. 16 (Sales, Exchanges, and Other Transfers of Partnership Interests) (WG&L).

8 Treas. Reg. § 1.1001-3; IRC § 108(e)(10) (issuer recognizes cancellation of indebtedness income if the issue price of the new modified instrument is less than the adjusted issue price of the old unmodified instrument). A significant modification may also give rise to original issue discount. Certain debt for debt exchanges may be treated as recapitalizations under IRC Section 368(a)(1)(E).

9See preamble to debt modification regulations under Treas. Reg. section 1.1001-3; T.D. 8675, 1996-2 C.B. 60; Rev. Rul. 90-109, 1990-2 C.B. 191; James Peaslee, Modifications of Nondebt Financial Instruments as Deemed Exchanges, 95 TAX NOTES 737 (Apr. 29, 2002); Treas. Reg. §§ 1.446-3(h), 3(f), (g)(4) (treatment of termination payments on notional principal contracts); Treas. Reg. § 1.1001-4 (exception to gain for nonassigning counterparties for swaps novated between dealers under agreements permitting such novation).

10 IRC §§ 382(g) and (l), 336(d)(2). See also sources cited supra note 6. Consider, for example, IRC section 382(k)(6)(B), under which the IRS may treat an instrument that is equity for tax purposes as "not stock" for purposes of IRC section 382, and may treat "convertible debt interests and other similar interests" as "stock" for such purposes.

11 Treas. Reg. § 1.1502-13.

12See, e.g., Cal. Rev. & Tax. Code § 23362 (California); N.Y. Reg. § 3-9.4 (New York). See generally Thomas Giegerich, Selected Tax Considerations in Corporate Restructuring, in THE CORPORATE TAX PRACTICE SERIES: STRATEGIES FOR ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS (PLI 2009).

13See generally Bernita Thigpen, Arvind Venigalla & Brenda Zent, The Direction of a Merger -- Federal Income Tax Consequences, in THE CORPORATE TAX PRACTICE SERIES: STRATEGIES FOR ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS (PLI 2009); Lewis Steinberg, Form, Substance and Directionality in Subchapter C, 52 TAX LAW. 457 (1999). Consider also the potential application of the liquidation-reincorporation doctrine, "north-south"/deemed exchange characterization, circularity of cash flow and similar step transaction principles. In addition, when reviewing living will transactions as a whole, consider whether dispositions or winding-down of businesses might affect the satisfaction of "continuity of business," "active trade or business" or similar requirements that might apply to other transactions involving the same or related entities.

14 Treas. Reg. § 1.368-2(l).

15 IRC § 197(f)(9).

16 Under the Subpart F rules, the transferring CFC will not suffer an immediate tax assuming it qualifies for the active financing exception under IRC sections 954(c)(2)(C) and/or (h). There is an exception from foreign personal holding company income in IRC section 954(c)(1)(B) for income from the sale of IRC section 954(h) property. This exception covers sales of assets by CFCs that fall within the ambit of section 954(h). Additionally, Treas. Reg. sections 1.954-2(e)(1) and (3) generally should provide protection from foreign personal holding company income treatment for gains from the sale of dealer property and intangible assets (including goodwill and going concern), respectively, used in an active trade or business.

17 IRC §§ 901(m) (covered asset acquisitions), 909 (dealing with foreign tax credit splitter transactions); Notice 2010-92, 2010-52 I.R.B. 916 (setting out rules for pre-2011 splitter transactions).

18 Treas. Reg. § 1.332-2(b). See also Prop. Treas. Reg. § 1.351-1(a)(1)(iii); Prop. Treas. Reg. § 1.368-1(f); the preamble to the proposed "no net value" regulations at 2005-1 C.B. 835. But see Norman Scott v. Comm'r, 48 T.C. 598 (1967). See also Thomas Avent, Liquidations, Reorganizations and Contributions Involving Insolvent Corporations, in THE CORPORATE TAX PRACTICE SERIES: STRATEGIES FOR ACQUISITIONS, DISPOSITIONS, SPIN-OFFS, JOINT VENTURES, FINANCINGS, REORGANIZATIONS & RESTRUCTURINGS (PLI 2009).

19 Worthless stock deductions are provided for in IRC section 165(g). In the case of stock of members of a consolidated group, see Treas. Reg. sections 1.1502-80(c) and -19(c)(iii). Worthless stock of an affiliate may give rise to an ordinary loss under IRC section 165(g)(3). However, a liquidation of a company may be treated as a sale or exchange giving rise to a capital loss. Treas. Reg. § 1.332-2(b); Comm'r v. Spaulding Bakeries, 252 F.2d 693 (2d Cir. 1958). Section 267 does not apply to losses on a distribution in liquidation. IRC § 267(a)(1).

20 Worthless debt constituting a "security" is treated under IRC section 165(g); other bad debts are covered by IRC section 166.

21 Literally, the market discount rules in IRC sections 1276-1278 would appear to apply to distressed debt bought at a deep discount. However, the legislation does not seem to be directed at this situation, and these rules arguably may not apply to such transactions.

22See supra notes 8 and 9.

23 The restructuring may result in an entity having a physical presence in a new state. Equally important, it may impact economic nexus considerations. Megan Stombock, Economic Nexus and Nonresident Corporate Taxpayers: How Far Will it Go?, 61 TAX LAW. 1225 (2008); Andrew Swain & John Snethen, Economic Nexus: Past, Present and Future, 44 STATE TAX NOTES 243 (Apr. 23, 2007).

24 In general, a "permanent establishment" is a "fixed place of business" through which the business of an enterprise is carried on in whole or in part. 2006 U.S. Model Income Tax Convention, art. 5(1). A similar definition is contained in Article 5 of the OECD Model Tax Convention on Income and on Capital.

25 Treas. Reg. § 1.482-1(d)(3)(i); TRANSFER PRICING GUIDELINES FOR MULTINATIONAL ENTERPRISES AND TAX ADMINISTRATORS, ch. 1, § C(b)(2) (OECD 2010).

26 For the effect of terminating hedges, see Treas. Reg. section 1.446-4(e)(6) and IRC sections 475(b) (1)(C) and (b)(2).

27 For a thorough discussion of this area, see the preamble to the regulations under IRC section 987, 2006-2 C.B. 698.

28 Under APB 23, a U.S. tax accrual is not imposed on the foreign earnings of a controlled foreign corporation if the foreign earnings are indefinitely invested overseas.

29 For an overall discussion of hedge fund and private equity fund tax issues, see Richard Lipton & John Soave III, U.S. Taxation of Private Equity and Hedge Funds, in THE PARTNERSHIP TAX PRACTICE SERIES: PLANNING FOR DOMESTIC AND FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES (PLI 2008); and Jerald August & Lawrence Cohen, Hedge Funds -- Structure, Regulation and Tax Implications Structure and Regulation, in THE PARTNERSHIP TAX PRACTICE SERIES: PLANNING FOR DOMESTIC AND FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES (PLI 2010).

 

END OF FOOTNOTES TO APPENDIX A

 

 

* * * * *

 

 

Appendix B

 

 

Push-Out Rule Tax Issues Grid

 

 

Background

"The push-out rule will apply mainly to banking entities employing trading personnel and having swaps on their books. Here, three alternatives need to be considered -- (i) the bank transfers the trading personnel to a non-bank affiliate, leaves the existing swaps in the bank, and books all new swaps in the affiliate, (ii) the bank transfers the trading personnel to a nonbank affiliate, and novates existing swaps to and books all new swaps in the affiliate, (iii) the bank transfers the trading personnel to a non-bank affiliate, leaves the existing swaps in the bank and transfers the risk on the existing swaps by mirror swaps to the affiliate. The third alternative will be of limited application because of bank regulatory constraints under section 23A/B of the Federal Reserve Act and because back-to-back transactions may require capital in both entities involved. If the existing swaps are booked in a non-bank affiliate and the bank employs trading personnel, the bank will only need to move the trading personnel to the affiliate. The bank and the non-bank affiliate are both assumed to be swaps dealers. The tax issues arising under these four scenarios are outlined below.

 

_____________________________________________________________________

 

 

Alternatives

 

Trading personnel and swaps book are in the bank

 

Alternatives

 

1) Move trading personnel to non-bank affiliate (NBA), book new swaps in NBA and leave existing swaps in the bank

 

Move Trading Personnel

 

Possible issue regarding workforce in place intangible

 

Move Existing Swaps

 

N/A

 

Change Booking Entity for New Swaps

 

Possible issue regarding customer based and business opportunity intangibles

 

Tax on Goodwill

 

May trigger gain on goodwill
_____________________________________________________________________

 

 

Alternatives

 

2) Same as alternative (1) except novate existing swaps over to NBA

 

Move Trading Personnel

 

Possible issue regarding workforce in place intangible

 

Move Existing Swaps

 

Possible gain on swaps positions but probably small because of IRC section 475 rules; may trigger gain or loss for counterparties on existing positions; NBA will make or receive a termination payment to/from the bank and should step into the shoes of the bank on the swaps positions

 

Change Booking Entity for New Swaps

 

Possible issue regarding customer based and business opportunity intangibles

 

Tax on Goodwill

 

May trigger gain on goodwill; most likely scenario to trigger such gain
_____________________________________________________________________

 

 

Alternatives

 

(3) Same as alternative (1) except move market (and, possibly, credit) risk by mirror swaps to NBA

 

Move Trading Personnel

 

Possible issue regarding workforce in place intangible

 

Move Existing Swaps

 

NBA will make or receive an upfront payment to/from the bank, and this payment should be accounted for in a similar fashion to a termination payment

 

Change Booking Entity for New Swaps

 

Possible issue regarding customer based and business opportunity intangibles

 

Tax on Goodwill

 

May trigger gain on goodwill
_____________________________________________________________________

 

 

Alternatives

 

Swaps book is in NBA and some or all trading personnel are in the bank
_____________________________________________________________________

 

 

Alternatives

 

1) Move trading personnel to NBA

 

Move Trading Personnel

 

Possible issue regarding workforce in place intangible

 

Move Existing Swaps

 

N/A

 

Change Booking Entity for New Swaps

 

N/A

 

Tax on Goodwill

 

May trigger gain on goodwill
_____________________________________________________________________

 

 

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.

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