kpmg capital markets workshop

© 2013 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Capital Markets Workshop November 13, 2013

Presented by KPMG LLP

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Mark Price National Tax Leader, Banking and Capital Markets Mark Harrison Partner Elizabeth L’Hommedieu Tax Managing Director Justin Weiss Tax Managing Director

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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. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. 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.

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© 2013 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. © 2013 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Agenda

• Introduction: What are Derivatives? • Overview of Certain Key Aspects of the Dodd Frank Act Affecting Derivatives • Taxation of Derivatives

– Forward Contracts – Options – Swaps – Futures Contracts – Straddles

• Proposed Legislation Affecting Taxation of Derivatives • Hedging Transactions • Mark to Market – Section 475

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Introduction

• Where are we today? – Extremely complex labyrinth of tax and financial accounting rules with:

• Recent and pending statutory and regulatory changes to the tax rules • Pending changes to accounting rules under both GAAP and IFRS

– Significant increase in the use of derivatives (both for hedging and other purposes), combined with the implementation of fundamental changes to the market (i.e., the Dodd-Frank Wall Street Reform and Consumer Protection Act)

5


What are Derivatives?

6


Forward Contracts - Defined

• Future sales agreement between two parties – Over-the-counter (OTC) – Unconditional obligation to buy/sell

• Distinguish from a “regulated futures contract” – Standardized, exchange-traded

7


Profile – Forward Contract (Long Party)

-$50-$40-$30-$20-$10

$0$10$20$30$40$50

$50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Commodity Price

Prof

it / L

oss

CommodityForward Buyer

Forward purchase of commodity.

Spot = $100 & Forward = $110

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Profile – Forward Contract (Short Party)

-$50-$40-$30-$20-$10

$0$10$20$30$40$50

$50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Commodity Price

Prof

it / L

oss

CommodityForward Seller

Forward sale of commodity.

Spot = $100 & Forward = $110

9


Futures Contracts - Compared to Forward Contracts

• Forwards – over-the-counter, private contracts; customized – not marked to market under section 1256 (other than certain foreign exchange

contracts, see below) • Futures

– Standardized “forward-like” contracts traded on an exchange – Subject to margin and clearing rules – generally cash settled – marked-to-market under section 1256 – no counterparty credit risk

10


Options – Definition and Terminology

• Option Defined • A contract that gives the holder the unconditional right (but not the obligation)

– To buy (call) or to sell (put) – A specified item – At a given “strike” price – On or by a specified date

• Can be cash settled or physically settled • Can be “listed” or “unlisted”

– If “listed,” potentially subject to section 1256

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Options - Payout Profile for Holder of Call

-$50-$40-$30-$20-$10

$0$10$20$30$40$50

$50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Commodity Price

Prof

it/Lo

ss

CommodityCall

$10 Premium $100 Strike Price

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Options - Payout Profile for Grantor of Call

-$50-$40-$30-$20-$10

$0$10$20$30$40$50

$50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Commodity Price

Prof

it/Lo

ss

CommodityCall


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Options – Payout Profile for Holder of Put

-$50-$40-$30-$20-$10

$0$10$20$30$40$50

$50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Commodity Price

Prof

it/Lo

ss

CommodityPut


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Options – Payout Profile for Grantor of Put

-$50-$40-$30-$20-$10

$0$10$20$30$40$50

$50 $60 $70 $80 $90 $100 $110 $120 $130 $140 $150

Commodity Price

Prof

it/Lo

ss

CommodityPut


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Options - Collars

• Characteristics – Generally, a collar is a combination of a put and a call option – Combination gives right to either all of the economics of an investment, or all except for

within a specific price range – The price of a collar is the net cost of the options used to create the collar – The strike prices of the two options are usually set to provide for zero net premium

• Examples – Long put option with short call option

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Swaps - Overview

• Counterparties – Contract between two parties (“counterparties”) to exchange a series of cash flows over

time • Periodic Payments

– The parties exchange payments on specified dates (“periodic payments”) • Payments – *Netting*

– Payments calculated by multiplying two amounts • “Notional Principal Amount”; and • “Specified Index”

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Interest Rate Swap

• Company A issues bonds – Pays floating interest rate (LIBOR) – Principal amount of the bonds $10M; term 5 years – A believes interest rates will rise so wants to lock in fixed rate

• Company B issues bonds – Pays fixed interest rate 8% – Principal amount of the bonds $10M ; term 5 years – B believes interest rates will fall so willing to pay based on floating rate

• A and B enter into an interest rate swap – 5 years with net payment due 12/31 each year – A will pay B 8% of $10M (the notional principal amount) – B will pay A LIBOR times $10m (the notional principal amount)

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Interest Rate Swap

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LIBOR x $10MM

Company A fixed for floating

Company B floating for fixed

Debt Holders

LIBOR x $10MM

8% x $10MM

8% x $10MM

Debt Holders

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Credit Default Swaps

• A credit default swap provides exposure to credit • Protection Buyer

– Makes fixed payments on a periodic basis – No requirement for buyer to own underlying asset (debt instrument)

• Protection Seller – Makes a payment to the protection buyer if a “credit event” or “credit default” occurs

regarding the underlying asset/entity.

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Overview of Certain Key Aspects of Dodd Frank Act Affecting Derivatives

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Background

• Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) enacted in 2010.

• Tasks the SEC and CFTC with implementing the sweeping changes to the derivative markets provided for under Title VII of the Dodd-Frank Act.

• Promulgation and implementation of the vast rules contemplated under Title VII is currently ongoing

– However, many rules are currently in force and all indications are that rules will continue to be rolled out on an ongoing basis

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Title VII of the Dodd-Frank Act

• Changes to the OTC Derivatives Markets Under Title VII Include: • Mandatory central clearing for many “swaps” (defined in Dodd-Frank Act) • Requirement for trading in many “swap” transactions on exchanges or so-called “swap

execution facilities” – “Swap Execution Facilities” – nature of these trade execution facilities remains unclear

• New collateral and margining requirements • Trade reporting and record-keeping requirements • Position limitations • End-User Exception – may exempt certain users of derivative products from some of these

new rules and requirements – Detailed rules define scope of this exception

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Basics of Central Clearing Illustrated

Derivatives Clearing Organization

(Clearinghouse)

Party X Party Y

Swap Terms Agreed on OTC Basis

Trade submitted by parties to DCO for

clearing

1

2

3Cleared Swap Trade

3Cleared Swap Trade

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Comparing Derivatives Markets Pre & Post Dodd-Frank Act Post Dodd-Frank Act

Many Derivatives Executed on an OTC Basis

Clearing Generally at Discretion of Parties

OTC Execution Carried Greater Likelihood of “Bespoke” Terms

More Likely Derivatives Executed on Exchanges

(or “SEFs”)

Mandatory Clearing for Many Derivatives

Greater Emphasis on “Standardized” Terms

Proliferation of New Swap & “Swap-Like” Derivative

Products

PLUS

Pre Dodd-Frank Act

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Tax Implications of Dodd Frank Act

• Dodd-Frank Act will likely lead to more derivatives being traded on exchanges. – Broad definition of “swap” for regulatory purposes suggests many derivatives may be

cleared / traded on exchanges. – Potentially subject to section 1256 as a result?

• New section 1256(b)(2)(B) provides that a section 1256 contract does not include: – Any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor,

commodity swap, equity swap, interest rate floor, equity index swap, credit default swap, or “similar agreement”

• Uncertainty as to what this exception covers – “…or similar agreement” – If instrument is covered by the exception, no 60/40 capital gain or loss treatment under

section1256 even if such instrument is centrally cleared or traded through a clearinghouse or exchange.

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New Exchange-Traded “Swap-Futures” Products

• New swap-futures products suggest that efforts are also underway to “futurize” the swap markets

• Examples include: – Exchange-traded and cleared futures contracts that settle into a cleared interest rate

swap – Exchange-traded and cleared futures contracts that are intended to replicate the

economics of an OTC interest rate swap but are entirely cash settled and function in a manner similar to traditional financial futures contracts

• In general, these derivative products share the following key features: – Generally standardized terms – Traded on “designated contract markets” and subject to margining and a daily “marking-

to-market” in the same fashion as traditional exchange-traded futures contracts • Each day, the parties to these derivative contracts will post “daily variation margin”

as the value of the contract moves and it is “marked-to-market” – Centrally cleared as a matter of course

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DFA and Qualified Boards or Exchanges Potential Changes

• What trading platforms qualify as a “qualified board or exchange” may be subject to change due to Dodd Frank.

– Whether contract is traded on or subject to the rules of a “qualified board or exchange” is a key factor in determining whether subject to section 1256.

• Historically, Treasury has issued guidance as to whether a particular exchange met the standard and qualified.

– Foreign exchanges typically requested a ruling from the Service as to their status under the tax rules.

• Dodd Frank authorizes the CFTC to impose a registration process on exchanges. – Service has indicated that if such a registration process is adopted by the CFTC,

exchanges that previously received a written determination on their status as a “qualified board or exchange” would nevertheless need to obtain an Order of Registration from the CFTC in order to maintain this status.

– Treasury and the IRS have stated that they will continue to evaluate the CFTC’s rules to determine if any changes to the IRS guidance process are warranted.

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Dodd-Frank Act (Other Tax-Relevant Provisions)

• Derivatives

– Banks must limit swap dealings to certain permitted activities • May have to transfer swap portfolios to nonbank affiliates (“Swap Pushout Rule”) • Temp. Reg. section 1.1001-4 issued regarding transfer or assignment of certain

derivative contracts – Mandatory clearing of swaps; reporting and record-keeping requirements

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Taxation of Derivatives – Introduction and Overview

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Introduction

VS.

Other: - Accounting for Upfront

Payments

Timing Rules

Hedge Timing Rules

Straddle Rules

Mark to MarketOpen Transaction

Character Rules

Tax HedgingTreatment

Termination Payments

§1256 (60/40)

Written Options §988

Status of Taxpayer

§475 Dealers & §475 Elections

Commodities Derivatives

Dealer

Member of Consolidated Group

Hedging & Subpart F

Other

Hedging & §199 Deduction

State Apportionment Rules

Special Derivative Withholding

Rules

General Character Rules (§1221)

Affirmative Use of Identifications

NPC Timing Rules

§475

Source

Hedgers, Traders or Investors

“Significant” Nonperiodic

Payments

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How we might approach the issue

• What is the classification of the derivative contract for tax purposes? • What are the generally applicable character and timing rules applicable to the derivative

contract (i.e., the “base case”)? • Who is the taxpayer and how does the derivative contract relate to its business? • Has the taxpayer made any elections or taken affirmative steps to alter the taxation of its

derivative contracts from the “base case”? • See Sample Decision Tree on Next Slide

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How we might approach the issue (continued)

• Taxation of many derivative transactions is based on a great number of intertwined rules that can produce different results depending on things like the classification of the derivative or the hedged item, the status of the taxpayer, elections or identifications made, the relation of the position to other positions held by the taxpayer.

• The following is an example of a single position which begins to demonstrate this.

Foreign Currency Position

Mark-to-market under §475 – ordinary income/loss

Mark-to-market under §1256 – 60% long-term, 40% short-term capital gain/loss [due to §988

election]

Other

Spot Forward

Cash Settlement

Physical Settlement

Not part of a straddle

Part of a straddle

Other contract traded in the interbank market,

where its price is determined by reference

to the price in the interbank market, and the foreign currency is of the

type that underlies positions in regulated

futures contracts, but not a NPC.

Regulated Futures Contract, but not a Notional Principal

Contract (NPC)

Mark-to-market under §1256 – 60% long-term, 40% short-term capital

gain/loss

Mark-to-market under §1256 – ordinary income/

loss under §988

Other Forward

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What is the classification of the derivative contract for tax purposes?

• Tax rules for derivative contracts dictated largely by the unique features of the derivative contract

– Have to determine what the contract is for tax purposes: • Forwards • Futures • Swaps/Notional Principal Contracts • Options • Other?

– Some derivatives are defined under the tax rules (e.g., “futures”) while others are not (e.g., “forwards”)

– Even if economics are similar, the characterization for tax purposes as one or the other can markedly affect the taxation

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What is the classification of the derivative contract for tax purposes? (continued)

• Key Considerations – Where was the contract acquired?

• Exchange traded/cleared contracts vs. “over-the-counter” transactions • Who is the counterparty • Evolution in the derivative markets and Dodd Frank Act

– What does the contract provide for? • Optionality vs. “executory” contract • Physical settlement • Cash settlement • Payments by both parties and netting • Upfront premium payments or similar amounts

35


General tax rules applicable to derivatives – the “base case”

• Timing – what is proper method of accounting for derivative? – “Open transaction” or “realization” based taxation

• Forwards • Certain Options

– NPC timing rules (section 1.446-3) – “Mark-to-Market” regime (section 1256)

• Futures – Straddle Rules (section 1092)

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General tax rules applicable to derivatives – the “base case” (continued)

• Character – Capital v. Ordinary – May be determined by type of contract or underlying asset. For example:

• Certain payments on Swaps/Notional Principal Contracts are ordinary in nature by (proposed) regulation

• Section 988 – certain FX contracts give rise to ordinary income/loss • Section 1256 – certain contracts subject to special character rule (60% long term

capital/40% short term capital) • Other

– Section 1234A and termination or similar transactions – Section 1234(b) and written options

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General tax rules applicable to derivatives – the “base case” (continued)

• Key Takeaways – Absent Taxpayer Elections or Affirmative Steps: – Some derivatives may be subject to mark-to-market regime while others not – Character may depend on the nature of the contract and the nature of the payment

with respect to the contract – Hedging transactions – generally applicable tax rules may create mismatches as to both

character and timing between the hedge and the hedged item if no hedging identification is made and there are various “whipsaw” rules that can exaggerate the consequences of failing to properly identify hedging transactions

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Taxpayer characteristics and affirmative steps

• Taxpayer’s status and how the derivative relates to its business may affect the taxation of the contract

– Hedging Identifications – Section 475

• Is taxpayer a “dealer” in securities? • Has taxpayer made one of the section 475 elections (for traders in securities or

dealers or traders in commodities)? – Commodities derivatives dealer status (section 1221(a)(6))

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Taxpayer characteristics and affirmative steps (continued)

• Consolidated Groups – Unique issues may arise where taxpayer is member of a consolidated group and the

derivative contract relates in whole or in part to the operations and risks of another member of the group or an affiliated entity not within the consolidated group for tax purposes (e.g., CFC affiliate)

• Separate entity election under hedging regulations • Implementing a “back-to-back” structure with central “hedging center” entity • Consider related issues such as transfer pricing

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Taxpayer characteristics and affirmative steps (continued)

• Does the taxpayer claim the section 199 deduction? – Identification requirements for hedging transactions and calculation of section 199

deduction • Is the taxpayer a CFC subject to the rules of subpart F?

– Identification requirements for a CFC’s hedges of its own risks • Foreign counterparty and withholding implications? • What special state apportionment rules might be applicable to the derivative contract?

– EX: are gross receipts or net gains (or neither) from a hedging transaction included in a taxpayer’s sales factor?

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Taxation of Derivatives – Forward Contracts

42


Forward Contracts – Taxation (Timing)

• General Rule – Open Transaction • Cash Settled

– Seller consequences? – Buyer consequences?

• Physically Settled – Seller consequences? – Buyer consequences?

43


Forward Contracts – Taxation (Character)

• Physically settled? • Cash settled? • Application of §1234A

– Character of payments made in connection with cancellation, termination, expiration or lapse of forward may depend on character of the “underlying” or asset sold

44


Taxation of Derivatives – Options

45


Taxation of Over-the-Counter Options

• Tax Treatment of Holders – Generally – open transaction treatment – Treatment of option premium – Physical or cash settlement? – Lapse or Sale of Option

46


Taxation of Over-the-Counter Options

• Tax Treatment of Grantor – Generally – open transaction treatment – Treatment of option premium – Physical or cash settlement? – Closing Transaction or Lapse

47


Options - OTC Option Example

• A purchases a call option from B on 1,000 shares of XYZ Co. stock. • A pays $10,000. • The strike price is $100/share. • The stock is trading at $106/share on the exercise date.

48


Options - Taxation of Listed Non-equity Options

• Types of non-equity options – Interest rate options – S&P 500 Index options – Options on debt – Options on commodities

• Section 1256 governs – See below

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Options – Other Issues

• Deep-in-the-Money Options: – Generally, the purchase or grant of an option does not cause a current sale of the

underlying asset for tax purposes – Exception for “deep in the money” options – Economic compulsion to exercise (not really an option)

• Anti-Abuse Rules – A single option, in combination with another position in the underlying asset, also might

create a straddle under section 1092 (see below)

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Options - Collars

• Characteristics – Generally, a collar is a combination of a put and a call option – Combination gives right to either all of the economics of an investment, or all except for

within a specific price range – The price of a collar is the net cost of the options used to create the collar – The strike prices of the two options are usually set to provide for zero net premium

• Examples – Long put option with short call option

• Issues – Tax Characterization – is it an option? A “NPC”? – Constructive Sales and Section 1259 – Straddles

51


Taxation of Derivatives – Swaps

52


Swaps - Overview

• Counterparties – Contract between two parties (“counterparties”) to exchange a series of cash flows over

time • Periodic Payments

– The parties exchange payments on specified dates (“periodic payments”) • Payments – *Netting*

– Payments calculated by multiplying two amounts • The Notional Principal Amount • Specified Index

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Common Swaps

• Interest rate swaps • Commodity swaps • Currency swaps • Equity • Others

– Weather – Energy

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Taxation of Swaps

• Timing and Character rules found in Treas. Reg. §1.446-3 • Tax term is “notional principal contracts” or “NPCs”

– “a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts”

– Proposed regulations • Examples noted in regulations include: interest rate swaps, currency swaps, commodity

swaps, equity swaps and “similar agreements”

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Notional Principal Contract

• Excluded contracts – §1256(b) contracts – Futures – Forwards – Options – Debt instruments

• Must use a qualifying index – Fixed price, rate, or amount based on objective financial info

56


NPCs - Payments

• Regulations define three types of payments – Periodic payments – Nonperiodic payments

• Contingent • Noncontingent

– Termination payments

57


NPCs - Periodic Payments

• Generally, NPC payments payable at intervals of one year or less – Payable during the entire term of the contract – Based on a specified index and notional amount

• Timing – Allocated pro-rata over the period to which they relate

• Character – Ordinary

• Including final periodic payment • Not considered interest

58


NPCs - Nonperiodic Payments

• Defined by exclusion as any payment made or received that is not either a periodic payment or a termination payment

– Can be contingent or noncontingent • Examples

– Premium for cap or floor – Payment for an off-market swap agreement (i.e., a swap premium or yield adjustment

fee) – Prepayment of part or all of one leg of a swap – Premium for option to enter swap when and if exercised

59


NPCs- Nonperiodic Payments

• Character – Ordinary

• Timing – Recognized over the term of the NPC in a manner that reflects the economics of the

swap – Regulations provide a number of alternative methods for recognizing nonperiodic

payments over the term of the NPC depending on whether they are noncontingent or contingent

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NPCs - Termination Payments

• Definition – A payment made or received to extinguish, assign or exchange all or a proportionate

share of the rights remaining under NPC • Timing

– Recognized in the year NPC is extinguished, assigned, or exchanged • Character

– Generally capital – But see hedging transactions

61


NPCs – Examples of Periodic and Nonperiodic Payments

• Example 1: A enters into 3 year commodity swap with B. A will make annual payments to B based on a fixed price $2.35 per bushel of corn on a notional amount 100K bushels. B will make annual payments to A equal to the spot price of corn on the same notional amount. A pays B premium of $53,530 on entering into swap.

• Example 2: A and B enter into a swap. A makes annual payments to B equal to LIBOR times a notional amount for 5 years. B agrees to make a single payment at maturity equal to the appreciation (if any) of a notional investment in a basket of securities.

• Which of these payments are periodic payments and which are nonperiodic payments? • Of the nonperiodic payments, which are contingent and which are noncontingent?

62


NPCs and §871(m)

• Section 871(m) treats “dividend equivalent” payment as a dividend sourced within the U.S. if the amount of the payment is contingent upon or determined by reference to the payment of a dividend from sources within the U.S.

• Effectively changes the sourcing of dividend equivalent payments made on notional principal contracts.

– Reg. §1.863-7(b), the source of NPC income determined by reference to the residence of the TP.

• Temporary and proposed regulations issued in 2012

63


Taxation of Derivatives – Futures Contracts

64


Futures Contracts - Overview

• Standardized “forward-like” contracts traded on an exchange • May be subject to special timing and character rules under section 1256

65


Futures Contracts - Compared to Forward Contracts

• Forwards – Over-the-counter, private contracts; customized – Not marked to market under section1256 (other than certain foreign exchange

contracts, see below) • Futures

– Standardized, traded on exchange; subject to margin and clearing rules – Generally cash settled – Marked-to-market under section 1256 – No counterparty credit risk

66


Futures Contracts – Tax Definition

• “Regulated futures contract” is defined in section 1256: – Contract that is subject to a system of marking-to-market – Contract trades on, or regulated by, a “qualified board or exchange”

67


Other Section 1256 Contracts

• Certain Foreign Currency Contracts – Requires delivery of, or the settlement of which depends on the value of, a foreign

currency which is a currency in which positions are also traded through regulated futures contracts,

– Which is traded in the interbank market, and – Which is entered into at arm's length at a price determined by reference to the price in

the interbank market. • Nonequity Options

– Dealer Equity Options – Dealer Securities Futures Contracts

68


Taxation of Section 1256 Contracts

• Mark-to-market regime for gain/loss • Mark-to-market section 1256 contracts at

– Year-end – Termination – Assignment – Physical delivery (compare to forward contract)

• The amount of gain or loss is adjusted to reflect any gain or loss previously taken into account • 60/40 rule • Several important exceptions

– Foreign Currency Contracts

69


Taxation of Derivatives – Straddles

70


Introduction - §1092

• Straddle: “Offsetting positions” in “actively traded personal property” – Offsetting positions

• A “substantial diminution of risk of loss” from holding one position in personal property by reason of TP holding one or more other positions w/r/t personal property

– Personal property • Property (including stock) of a type that is actively traded

– Position • Direct and derivative ownership

71


Loss Deferral

• Loss realized from a position that is part of a straddle is deferred to the extent of unrecognized gain at year-end in ANY offsetting positions or successor positions.

– Unbalanced straddle? – Identified straddle regime – Mixed Straddles

• Holding period rules • Expense capitalization rule

72


Straddle - Example

• Facts – On September 1, 2012, A enters into a long forward contract to buy stock for delivery in

February 2013. A also enters into a short forward contract to sell stock for delivery in April 2013.

– By December 1, 2012, the price of the stock has increased. A closes out the April 2013 forward contract at a loss of $1000.

– On February 1, 2013, A closes out the remaining forward contract at a gain of $980. • What are the tax implications of this transaction to A under the straddle rules?

73


Proposed Legislation on Taxation of Financial Products

74


Proposed legislation provisions

• Part 1 – Derivatives and Hedging – Sec. 401. Treatment of derivatives. – Sec. 402. Treatment of hedges identified for financial accounting purposes.

• Part 2 – Treatment of Discount and Income – Sec. 411. Determination of issue price in the case of specified debt modifications. – Sec. 412. Deduction for amortizable bond premium allowed in determining adjusted

gross income. – Sec. 413. Current inclusion in income of market discount. – Sec. 414. Rules regarding certain government debt.

• Part 3 – Certain Rules for Determining Gain and Loss – Sec. 421. Cost basis of specified securities determined in accordance with average basis

method. – Sec. 422. Wash sales by related parties.

75


Sec. 401. Treatment of derivatives

• Require all derivatives to be marked to market for tax purposes – Relies on fair value determined in report or statement to owners or report or statement

for credit purposes • Treat all income, gain, loss, or deduction from derivatives as ordinary • Require other positions to be marked to market if part of a straddle with a derivative

– Built-in gain, but not loss, is included on entering into straddle • Replace several existing rules (e.g., portions of section 475, section 1234B, section 1236, and

section 1256) • Apply to property acquired and positions established after December 31, 2013

76


Sec. 401. Treatment of derivatives (continued)

• The term “derivative” is defined to include: • Derivative interests in

– Stock, partnership interests, trust interests – Note, bond, debenture, or other evidence of indebtedness – Real property (subject to exceptions) – Actively traded commodity – Currency

• An expanded definition of notional principal contracts • Embedded derivative components of debt instruments

– “Any terms that affect some or all of the cash flows or the value of other payments required by the instrument in a manner similar to a derivative”

77


Examples

• Taxpayer buys a call option on a U.S. publicly traded equity • Taxpayer enters into a contract to acquire a privately held partnership interest in a year • Taxpayer regularly enters into physical forward contracts to sell its property. These contracts

are treated as normal sales and not subject to the mark-to-market rules in ASC 815 • Taxpayer holds a corporate bond portfolio as part of its liquidity management program.

Taxpayer enters into interest rate swaps to manage its interest rate exposure • Taxpayer issues convertible debt

78


Sec. 402. Treatment of hedges

• Existing law requires hedging transactions to be identified for tax purposes as hedging transactions on or before the day the transaction is entered.

– Financial accounting identification does not meet this requirement • New provision treats designation of derivative as hedging transaction for US GAAP audited

financial statements as a valid hedge identification for tax purposes. • Transaction must still meet the substantive tax requirements to qualify as a tax hedging

transaction. • New provision would apply to transactions entered into after December 31, 2013.

79


Hedging Transactions

80


Hedging - Topics

• Overview • Requirements for a tax hedge • Identification requirements • Integrated debt instruments • ASC 815 (Formerly Known as SFAS 133)

81


Hedging - Overview

• Reason for undertaking hedging transaction? • Risk Management (reduction)

– Taxpayers use derivative transactions to manage risk inherent in the operation of their business

– Risk may arise from a specific asset – Risk may arise from overall business operations

• Match character of hedged transactions – Normal trade or business operations typically generate ordinary income and losses – In absence of hedging treatment, potential capital character of gain or losses from

hedging transaction

82


Hedging – Overview (continued)

• Hedging Rules – A transaction must qualify as a hedging transaction under §1221 – A transaction must be properly identified as a hedging transaction

• The hedging rules are mandatory – Non-compliance could result in a character whipsaw – Gains from the transaction could be ordinary and losses capital

• Identification & Documentation is important – Hedging identifications should be revisited – ASC 815

83


Hedging – Requirements for Tax Hedge

• Requirements for Hedging Transactions – Entered into in the normal course of a trade or business – “Primarily” to manage certain risks resulting

• From holding ordinary property, or • Incurring certain obligations

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Hedging – Requirement 1 “Normal Course” of Trade or Business

• Broader concept than “ordinary course of trade or business” • Generally a transaction in the “normal course” is one that furthers a taxpayer’s trade or

business – Includes business expansion, other capitalizable activity – Usually not hard to meet if the taxpayer is in a trade or business – May become an issue if the entity entering into the transaction is not an operating

company but instead an SPV with no trade or business

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Hedging – Requirement 2 Intent

• “Primarily” to Manage Risk – Examines taxpayer’s intent – Based on all facts and circumstances

• Corporate minutes or other records are good evidence of intent • Should thus document rationale for entering transaction

– Cannot be a transaction entered into for speculative purposes exclusive of trade or business

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Hedging – Requirement 3 Types of Risk

• Types of Risk Transaction Can Manage – Interest rate risk – Price risk or – Currency risk

• Note: Revenue risk and credit risk are not mentioned

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Hedging – Requirement 4 Manage Risk

• Transaction must manage Risk • A transaction that is entered into to reduce risk is treated as managing risk • Can reduce aggregate risk or specific risk • Transactions that may manage risk

– Written options – Fixed to floating price hedges – Interest rate conversions – Counteracting hedges (transactions designed to counteract an existing hedge) – Recycled hedges (using the same hedging transaction to hedge a different asset or

liability) • Transactions that are not hedging transactions

– Purchase or sale of debt instrument, equity security or annuity contract

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Hedging – Requirement 5 Ordinary Property or Obligations

• Hedging transactions hedge risk regarding – Ordinary property and ordinary obligations

• Property is ordinary property only if a sale or exchange of the property by the taxpayer could not produce a capital gain or loss under any circumstances.

• Debt instruments are generally capital assets unless a dealer holds them – Exception for banks under §582

• Taxpayer does not need to currently hold hedged item – Example – TP expects to borrow in 6 months may enter transaction to hedge against

increases in interest rates over that period even though not a current liability

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Hedging - Character Rules

• Character Matching – A properly identified hedging transaction permits characterizing the gain/loss from the

hedge as ordinary • Proper Identification

– May not qualify for character matching if TP fails to identify a hedge properly

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Hedging - Identification Requirements

• Taxpayer must clearly identify hedging transaction on day acquired, originated or entered into

• Taxpayer must identify the “hedged item” (e.g., the asset, liability or aggregate risk) within 35 days of entering the hedge

– Includes identifying transaction that creates risk and type of risk that transaction creates • Taxpayer maintains identifications on taxpayer’s books and records (nothing sent to IRS)

– Must state identification for §1221 (for tax purposes) – GAAP ID is insufficient (i.e. that used for ASC 815)

– Example: TP could designate particular trading account as including only hedging transactions and document in tax records that all interest rate swaps in that account designed to manage borrowing costs

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Hedging - Character Rules – TP Identifies Hedge

• If TP properly identifies hedge, and the hedging transaction qualifies as hedge, then ordinary income/loss

• If TP performs same-day identification but – – Other identification requirements are not met, gain is ordinary – The transaction does not meet the other criteria for a hedge, the character of loss is

determined without regard to whether the transaction mitigates business risk, etc.

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Hedging - Character Rules – TP Identifies Hedge (continued)

• If TP identifies as a hedge a transaction that does not qualify as a hedge, gain will be determined as if the identification had not been made so long as—

– The identification was an “inadvertent error” – All [similar] transactions in open years are being treated “consistent with the principles

of this section” [i.e., not as hedges] • Note -

– Scope of exception unclear – PLR suggests inadvertent = “accidental oversight or carelessness” (PLR 2000-52-010)

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Hedging - Character Rules – TP Fails to Timely Identify Transaction That Does Qualify as Hedge

• General Rule – Binding - transaction not hedge – Gain and loss determined without regard to whether transaction was surrogate for

noncapital asset • Inadvertent Error Exception

– TP’s failure to identify due to inadvertent error and TP treated transactions in all open years similarly

– Gain or loss from transaction may be treated as ordinary • Anti-Abuse Rule

– Generally if no reasonable grounds for treating transaction as other than hedging transaction, gain is ordinary

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Hedging - Identification Requirements – Specific Identification Rules

• Anticipatory asset hedges – Must identify the expected dates and amounts of the acquisition

• Inventory hedges – Must identify type or class of inventory that hedge concerns

• Debt hedges – Existing debt hedges – must specify the issue of existing debt being hedged – Debt to be issued – expected date of issuance, expected maturity, expected issue price,

and expected interest provisions

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Hedging - Identification Requirements - Specific Identification Rules (continued)

• Aggregate risk hedges – Must describe risk being hedged – Must describe hedging program under which hedging transaction was entered

• Counteracting hedges – Must identify the original hedge and the original hedged item

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Hedging - Timing Rules for Hedging Transactions

• Generally – The timing rules that govern hedging transactions (§1.446-4) require taxpayers to

choose a method that clearly reflects income – To clearly reflect income, the method must reasonably match the timing of income/loss

from the hedging transaction with the hedged asset • Taking gains or losses into account when realized may not clearly reflect income

• If a transaction meets the requirements for a hedge, hedge accounting applies whether or not the transaction is identified as a hedge (Rev. Rul. 2003-127)

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Hedging - Timing Rules for Hedging Transactions (continued)

• Choice of Timing Rule – TPs can choose any method that clearly reflects income (more than one method may be

reasonable) – Once taxpayer chooses method, it must apply that method consistently

• Record Keeping – In tax books and records, TP must include a sufficient description of the accounting

method used for each type of hedging transaction – Description must show how clear reflection standard is met

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Hedging - Specific Hedge Timing Rules that Generally Clearly Reflect Income

• Hedges of debt instruments – Coordinate income/deduction from hedge (covers specified periods) with interest or

OID on the debt • Example - Assume that a fixed-rate debt instrument is outstanding

– The taxpayer takes the income/deduction from the hedge into account in the same periods as income/deduction on debt as if adjusted the yield of debt over the term of the hedge

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Hedging - Specific Hedge Timing Rules - Example

• TP hedges fixed rate debt with swap that synthetically converts fixed rate into floating rate • Debt has 5 year term and swap has 5 year term • TP then terminates the swap before the 5 year term • Gain/loss from swap termination must be accounted for over the remaining period of the

debt to which the swap relates • So if TP terminates swap on last day of year 2, must take gain/loss from termination of swap

into account over years 3 - 5 of debt

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Hedges - Specific Hedge Timing Rules (continued)

• Disposition of Hedged Item – TP disposes of hedged item but retains hedge – TP must match “built-in” gain or loss on hedge with gain or loss from disposition of

hedged item – Usually accomplish by marking the hedge to market when dispose of hedged item – If intent to dispose of hedge within a reasonable period of time (7 days), then match

realized gain/loss from hedge with hedged item • Recycled Hedge

– TP must match the built-in gain/loss from the hedge at the time of the recycling with the gain/loss on the original hedged item

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Hedges - Relationship of Hedge Timing Rules to Other Timing Rules

• To the extent hedge timing rules conflict with other regulatory timing rules, hedge timing rules control.

• Hedge timing rules do not apply in the following cases: – A position subject to §475(a) – An integrated debt instrument – A §988(d) hedging transaction

• Note – Hedge timing rules do not alter the character of the gains/losses from the hedging

transaction to match hedged item – they govern timing

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Hedges - Integration of Debt Instrument and Hedge Under §1.1275-6

• §1.1275-6 provides rules that permit the integration of certain debt instruments with hedges of those instruments

– The debt and the hedge are not taxed separately – Instead one set of rules generally applies to the “synthetic instrument” that results from

the integration – E.g., Integration of fixed rate debt instrument and hedge in the form of a fixed to floating

rate swap results in the tax accounting for floating rate debt – Primary benefit is relief from character, timing and source mismatches that can arise

when debt accounted for separately from hedge

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Hedges - Integration of Debt Instrument and Hedge Under §1.1275-6

• Contrast to Business Hedge Rules – Rules apply to hedges of debt instruments – Debt does not have to be an ordinary asset or liability in the TP hands – Rules do not require TP to enter into the hedge in the normal course of its trade or

business – Rules lead to creation of synthetic debt instrument by integration

• Election – The rules only apply to the TP making the election – Thus if issuer of debt enters into hedge and integrates them, issuer’s integration

treatment does not affect the holder • Interest

– All interest is OID

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Hedges - §1.1275-6 – Example of Integration of Convertible Notes with Hedges

• AM 2007-0014 (July 16, 2007) – Corporation: – (1) Issues convertible bonds – (2) Purchases call options on stock with same strike price as option on convertible bond

(“bond hedge”) – (3) Sells call options on stock with a strike price significantly higher than strike price on

bonds (“warrant”) – Corp integrates convertible bond with purchased calls but not sold warrants – Corp’s economic position is that it has issued

• Non-convertible debt instrument at a discount, plus • Written warrant

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Hedges - §1.1275-6 – Example of Integration of Convertible Notes with Hedges (continued)

• AM 2007-0014 (July 16, 2007) (cont’d) • Ruling

– Corp may integrate bonds with hedges under §1.1275-6 and exclude warrants • Tax consequences?

– Potential issue: If corp structured to create excessive OID deductions through mispricing of hedges and warrants, such mispricing could be challenged through OID anti-abuse rule to prohibit integration of notes with hedges

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Mark-to-Market – Section 475

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Introduction to Section 475

• What makes a taxpayer subject to section 475? – Merely originating loans?

• How does being subject to section 475 affect timing and character? – Generally mark-to-market, ordinary for all securities (including loans)

• Exceptions? • Valuation? • Interaction with sections 1091, 1092, and 1256? • Special related party/consolidated return rules?

• Which consequences are elective? – Elections at the entity/group level – Identifications at the security level

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Section 475 Basics

• Section 475 (a) generally requires dealers in securities to use the mark-to-market method of accounting for their securities

• Dealer in Securities - A securities dealer is a taxpayer that either: – Regularly purchases securities from or sells securities to customers OR – Regularly offers to enter into, assume, offset, assign or otherwise terminate positions

• Purchases? – Purchase includes originating loans

• Customers? – Related parties may be customers

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Section 475 – What is a “Security”

• What is a Security? – Corporate Stock – Publicly traded or widely held partnership interests – Notes or other evidence of indebtedness – Interest rate, currency, or equity notional principal contracts – Interest or derivative in any security above – Hedges of MTM securities

• What is NOT a Security? – Taxpayer issued debt – REMIC residual interests – Non-financial customer paper – Section 1256 contracts

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Section 475 – Negligible Sales Exception

• Exception to Dealer Status – “Negligible Sales Exception” – Under this exception, a TP that regularly purchases securities (originates loans) from

customers in the ordinary course of its trade or business will not be considered to be a dealer in securities under section 475 if it:

• Sells all or part of fewer than 60 debt instruments; or • The total adjusted basis of all of the debt instruments sold is less than 5 percent of

the total basis of debt instruments acquired during the taxable year • Do not count -

– Sales that exceptional circumstances compel and that are non-recurring – Sales of debt based on its decline in quality under TP policy – Purchases and sales of debt instruments that are qualitatively different from

all debt instruments that TP purchases from customers in the ordinary course – What about agency sales and securitizations

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Section 475 Identifications

• Securities that TP may exempt from the mark-to-market rules – Securities Held for Investment (Regulations deem certain securities to be held for

investment) – Debt not held for sale to customers in the ordinary course of a trade or business – Hedges of investment securities

• Requirements for Exemption: – “Same day” identification – 30 day rule for loans originated by banks – Identification must be part of books and records – Must identify specific security (or specific accounts containing only such securities) – Identification must cite section 475

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Section 475 – IDs and Securitizations

• (1995) Proposed Regulation Section 1.475(b)-3 – Exemption from MTM treatment for Contributed Securities

• If a taxpayer expects to contribute securities (for example, mortgages) to a trust or other entity, including a REMIC, in exchange for interests therein the contributed securities qualify as held for investment or not held for sale only if the taxpayer expects each of the interests received to be either held for investment or not held for sale to customers in the ordinary course of the taxpayer's trade or business.

– Exemption from MTM treatment for Resulting Interests • If a taxpayer contributes securities to a trust or other entity in exchange for interests

therein (including ownership interests or debt issued by the trust or other entity) and if, for federal income tax purposes, the ownership of the interests received is not treated as ownership of the securities contributed, the interests received may be identified as being described in section 475(b)(1), even if some or all of the contributed securities were not so described and could not have been so identified.

– For purposes of determining the timeliness of an identification of an interest received, the interest is treated as acquired on the day of its receipt.

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Section 475 Protective Identifications

• Protective Identification – If a taxpayer becomes a dealer (perhaps because the taxpayer no longer qualifies for the

negligible sales exception) then all securities held by such taxpayer will be subject to the mark-to-market method of accounting unless they are exempt

• Even though the taxpayer was not a securities dealer at that time it bought/sold the securities

– It is not possible to subsequently identify securities and exclude them from mark-to-market accounting after the close of the day on which they were bought/sold

– May thus be advisable for a taxpayer to make protective section 475(b) identifications of its securities [e.g., classify them as exempt] if there is a possibility that such taxpayer may some day be considered a dealer

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Section 475 – Change in Status/Method of Accounting

• Change in Dealer Status – “Once a dealer, always a dealer” (Revenue Ruling 97-39) – Requesting a change to a mark-to-market method of accounting (Revenue Procedures

97-27 and 08-52) • A taxpayer electing out of the negligible sales exception must file a Form 3115 to obtain the

automatic consent of the IRS to change its method of accounting for securities – No section 481(a) adjustment required – Consent for the method change is automatically granted if taxpayer complies with

Revenue Procedure 97-43 – Once a bank is subject to section 475(a), changing to a non-mark-to-market method of

accounting in the future requires the consent of the IRS. • Non-automatic, with section 481(a) adjustment

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Section 475 – Ordinary Character Rules

• Generally, any gain or loss with respect to a 475 security shall be treated as ordinary income or loss

• Certain securities subject to section 475 are not subject to its character rule, including: – A security that a hedge with respect to either a security to which section 475 does not

apply or a non-security; – A security not held in connection with activities as a dealer in securities; and – Certain improperly identified securities (as defined in 475(d)(2)).

• Note that the mark-to-market rules under section 475 may still apply even though the character rule does not

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Section 475 Mark-to-Market Valuation

• “Safe Harbor” Regulations (securities and commodities dealers) – In June 2007, Treasury and the IRS adopted “safe harbor” valuation regulations that

permitted securities and commodities dealers to use their financial statement valuations as the fair market value of those positions for purposes of section 475.

– Because the 2007 regulations contain significant limitations, many taxpayers have concluded that the application of the safe harbor is not practical.

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Section 475 Mark-to-Market Valuation (continued)

• 2011 Directive – The Directive applies to all taxpayers who are required to, or elect to, MTM securities or

commodities under section 475 and are required to file certain financial statements with the U.S. SEC.

– The Directive relaxes some of the restrictive requirements in the safe harbor regulations. – Unlike the safe harbor regulations (which are limited to securities and commodities

dealers), the Directive is applicable in principle to traders electing to apply the section 475 MTM regime.

– However, limited in its application, because many traders may not file qualified financial statements with the SEC – a requirement.

– Similarly, many commodities dealers may not file qualified financial statements with the SEC; rather, they report to the Commodities Futures Trading Commission.

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Section 475 – Interaction with sections 1091, 1092, and 1256

• Section 1256 contracts are not section 475 securities – What if a section 1256 contract is a section 475(c)(3) hedge of a section 475 security?

• Section 1091 (wash sale rules) do not apply to securities subject to section 475 • Section 1092 (straddle rules) do apply, but may have a minimal impact if the offsetting

positions are subject to mark-to-market, ordinary under section 475

119


Section 475 in lieu of Section 166

• Some banks may want to use a mark-to-market method in lieu of section 166 – Election out of the negligible sales exception – Selectivity through identification

• e.g., acquisition of deeply discounted debt

120


Section 475 – Related Party Considerations

• Can a related party be a “customer”? – Outside the consolidated group – yes – Within the consolidated group – elective

• What happens when section 475 securities are transferred between a dealer and non-dealer in the same consolidated group?

– Section 475 is not a Reg. section 1.1502-13 “special status” – Transfer to dealer: deemed ID, then change in status – Transfer from dealer: no longer held in connection with dealer activity (affecting

character), but continue to mark-to-market

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Section 475 – Related Party Considerations

• How does a consolidated group apply the negligible sales exception? – Intragroup-customer election not in effect

• The test can be satisfied either by treating the members of the group as if they were divisions of a single corporation, or by taking into account sales of debt instruments to other group members.

– Intragroup-customer election in effect • Sales to other group members are taken into account when applying the test.

122


Section 475 – Elective Application for Certain Non-dealers in Securities

• Taxpayers that may elect into section 475 – Commodities dealers – Securities and commodities traders

• For activities to be considered a trade or business, trading must be substantial (i.e., sporadic trading not enough), TP Must seek to catch the swings in daily market movements, and to profit from the short-term changes, rather than profit from long-term investment

• Benefits of making a section 475 election: – Conform book/economic/tax income

• Avoid wash sales rules • Ordinary gains and losses

– Elect separately for each trade or business • “Principles” underlying the rules and interpretations for dealers apply to traders

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