Archive for the ‘Financial Products’ category

Could The New Economic Substance Statute Apply To End-Of-Year Stock Sales And Repurchases?

December 28, 2012

By Phil Karter

With the looming increase in tax rates on investment income and capital gains in particular, a large number of stock market investors have been selling long-term positions to lock in the 2012 rate, which currently tops out at 15%.  Come January 1,2013, gain on the same sale could be taxed at a rate as high as 23.8%, consisting of a long-term capital gains tax rate of 20% plus a Medicare surtax of 3.8% imposed on joint filers with AGI greater than $250,000 and single filers with AGI greater than $200,000.  (See Internal Revenue Code § 1411).

A question attracting attention as the year draws to a close and the pace of this activity has accelerated has been whether a stock sale undertaken solely to take advantage of the lower 2012 capital gains tax rates might fall within the scope of Code § 7701(o), the relatively new economic substance statute codified as part of the landmark Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029).  Concerns about coming within the scope of this statute are that it might subject the investor to a 20% penalty enacted as part of the new law.  See Code § 6662(b)(6).  The penalty, if applicable, is a “strict liability” one, which means that taxpayers cannot avoid it on grounds of reasonable cause, such as reliance on a tax advisor. (The penalty for a transaction determined to lack economic substance is also increased to a whopping 40% if the transaction is undisclosed.  See Code § 6662(i).  However, as long as a taxpayer reports the transaction on his or her tax return, the 40% penalty should not apply.)

Thankfully, the eleventh hour concerns expressed about this issue should be put to rest for stock investment gain-recognition transactions in 2012.  Even assuming the economic substance statute is conceptually broad enough to ensnare stock sale transactions undertaken to lock in lower capital gains tax rates, the penalty is only applicable to “underpayments.”  Because a long-term capital gain recognized in 2012 does not reduce a taxpayer’s taxable income but rather increases it (unless the gain is offset by otherwise unused capital losses), there is no underpayment against which to apply a penalty.

Now let’s vary the circumstances by introducing a simultaneous buyback of the stock at the time of sale to reestablish the same position.  Does that change anything vis a vis a potential penalty risk?  We still have a gain recognition transaction in 2012, so there is no tax underpayment against which a penalty could apply for this year.  As for the repurchased stock, its cost basis is at the repurchase price, which means that a subsequent sale in a future year will either produce a smaller taxable gain or larger taxable loss than would have occurred had the original share lots with their lower cost basis simply been maintained.  Some have speculated that this could produce a tax underpayment against which the strict liability economic substance penalty might apply in the year of sale.  After all, in defining a transaction that has economic substance, § 7701(o) requires (1) that the transaction change in a “meaningful way” the taxpayer’s economic position apart from federal tax benefits, and (2) that the taxpayer have a non-tax purpose for entering into the transaction.

In theory, a sale and instantaneous repurchase might fail to satisfy both of these tests.  On the other hand, a repurchase transaction that occurs sometime after the sale introduces an element of market risk from stock price fluctuation that should mitigate any penalty risk.  Similarly, a repurchase in a different type of account (e.g., in a tax-deferred account where the original sale was in a taxable account or vice versa) should also put the taxpayer on firmer ground.

So what are the real risks that the IRS might choose some unfortunate taxpayers to assert a strict liability penalty?  It has, after all, been less than forthcoming in providing guidance on what types of plain vanilla transactions, if any, may be viewed as falling within the scope of the new economic substance statute.  Perhaps the best indicator one can draw upon is the title of § 7701(o), “Clarification of Economic Substance Doctrine.”  The codified doctrine has been portrayed as merely a clarification of the economic substance law in effect for transactions entered into before March 30, 2010. Under the pre-codification doctrine, which is derived solely from the common law, there do not appear to be any reported economic substance cases involving a taxpayer’s sale and repurchase transaction that results in accelerated gain recognition. Couple this with the fact that no court has been asked to interpret the breadth of the new economic substance statute since it was passed in 2010, and it is reasonable to believe that the IRS would prefer to choose a different, and presumably more compelling battleground to make its first stand defending the application of Section 7701(o) and the strict liability penalty.

Finally, in the case of a 2012 gain-recognition stock sale and simultaneous repurchase, it cannot be entirely certain that the transaction will even produce a tax savings when all is said and done.  This is because of the difference between the tax rates for long and short term capital gains (which are taxed at ordinary income rates).  Because a new holding period is established for the repurchased stock, it remains possible that the stock, when sold, will produce a short-term capital gain subject to a larger tax burden than might have occurred if if the original long-term position was held into 2013 or beyond.  In the end, the lack of certainty about the ultimate tax effect until the second sale occurs may be taxpayers’ best argument that the sale and repurchase transaction had economic substance after all.

TARP’s “Godfather” Investment Should Give Rise To Deductible Interest

August 9, 2012

By:  Dustin Covello

Earlier this year, my former colleague Jonathan Prokup and I published an article in the Journal of Taxation and Regulation of Financial Institutions.  In the article, we considered the federal tax consequences of Treasury’s capital purchase program – the centerpiece of TARP.  Under the program, Treasury invested several hundred billion dollars into hundreds of our country’s banks to alleviate their perceived liquidity problems, which many believed to be the cause of the unfolding financial crisis.

Our article concluded that, even though most TARP instruments were nominally designated as preferred stock, the instruments actually constituted debt for tax purposes.  We reached this conclusion by applying the debt-equity factors that are classically used to classify hybrid instruments for tax purposes.  Most of these factors strongly support the classification as debt.  As a result, the tens of billions of dollars repaid on TARP investments could have been deducted by the banks as interest on their federal tax returns.

As new details continue to emerge about the October 2008 meeting that gave rise to TARP, our argument appears even more compelling.  In the article, we acknowledged that perhaps the most significant impediment weighing against debt characterization was that the TARP instrument was nominally designated as “preferred stock.”  As a general rule, courts are reluctant to allow taxpayers to determine the tax consequences of a transaction in a manner inconsistent with its papered form.  TARP was not, however, the product of arms-length negotiations.  Rather, Treasury mandated all of the terms of the TARP instrument each bank was pressured to accept, including its nominal form as preferred stock.  Given the duress placed upon the banks to accept the TARP investment, the banks may be able to disclaim the form of the TARP instrument even under the most restrictive interpretation of the general rule.  See Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 1967) (allowing taxpayer to disclaim the form of a transaction if the transaction would be unenforceable under common law contractual defenses such as duress).

In a speech this past June, former Wells Fargo CEO Richard Kovacevich recounted that fateful October 2008 meeting.  As described in the San Francisco Business Times, Mr. Kovacevich’s description of the meeting confirms the duress experienced by the banks to accept TARP investments.  In speaking to an audience at Stanford University, he said:

“Why didn’t I just say no and not accept the TARP money?”

“As my comments were heading in that direction in the meeting, Hank Paulson turned to Fed Chairman Ben Bernanke sitting next to him and said, ‘Your primary regulator is sitting right here. If you refuse to accept these funds, he will declare you ‘capital deficient’ Monday morning,'” Kovacevich recalled. “‘Is this America?’ I asked myself.”

“This was truly a ‘godfather moment.’ They made us an offer we couldn’t refuse,” Kovacevich said, adding that he might have put up more of a fight if the San Francisco bank … had not been trying to acquire troubled Wachovia at the time.

We are not aware whether any bank that accepted the TARP instrument in its nominal preferred stock form actually deducted “interest” paid on the instrument on its tax return.  Banks that did not originally claim the interest deduction may now pursue the interest deduction by filing a claim for refund.  Pursuing such a claim would incur small costs and create little risk, which would be far outweighed by the potentially hefty rewards.  However, despite the legal merits and potential rewards of such a refund claim, the statute of limitations has nearly expired for many banks to file one; by March 2011, banks had repaid Treasury over ninety-nine percent of invested funds.

Should Banks Be Entitled To Tax Deductions For “Dividends” On TARP Stock?

January 30, 2012

By Jonathan Prokup & Dustin Covello

Four years have passed since Congress enacted the Troubled Assets Relief Program, better known as TARP.  After Treasury determined that frozen credit markets were threatening the U.S. financial industry and even the entire economy, it asked Congress to authorize the purchase of illiquid mortgages from banks.  Congress obliged, authorizing Treasury to purchase up to $700 billion of these so-called “toxic assets.”

Soon after the enactment of TARP, Treasury Secretary Henry Paulson changed course and decided that investing directly in the banks would better serve TARP’s goals than would buying illiquid mortgages.  Readers may remember Paulson’s next extraordinary and unprecedented move: summoning the CEOs of our country’s nine largest banks to Washington, the Secretary informed each of them that they must accept $25 billion worth of TARP investments—no questions asked.  As one observer told the New York Times, Paulson’s “was a take it or take it offer. . . . Everyone knew there was only one answer.” (more…)

Treasury Finalizes Conduit Financing Regulations Under Section 881

January 9, 2012

By Jonathan Prokup

On December 9th, the IRS issued final regulations under Code section 881 that treat a disregarded entity as a person to determine whether a “financing arrangement” exists for purposes of applying the conduit financing regulations.  The finalized regulations may deny tax benefits otherwise available from U.S. tax treaties when a multi-party financing transaction is executed with a disregarded entity serving as an intermediary. (more…)

Businesses Prepare For The End Of The Euro; Will Treasury Do The Same?

November 29, 2011

By Jonathan Prokup

According to the Financial Times, companies around the world are preparing for the possibility of a breakup of the euro.  Given the currency devaluation that would likely occur in countries coming out of the euro, these companies are preparing for the impact that such an event would have on balance sheets (e.g., asset prices) and income statements (e.g., import costs).   (For additional FT coverage of the issue, see here.)

As we noted in the TaxBlawg a while back when the euro crisis was still focused primarily on Greece, a partial or complete breakup of the eurozone would give rise to a host of tax issues for U.S.-based multinationals.  Would a conversion from the euro to the drachma or the lira or another currency, as the case may be, create a realization event under Code section 1001?  Would the exchange give rise to currency exchange gain or loss under Code section 988?  Finally, if a taxpayer’s qualified business unit (“QBU”) were forced to switch its functional currency from the euro to a legacy currency, should that switch be considered a change in the taxpayer’s method of accounting for purposes of Code section 481?

The Treasury Department tackled these questions when the euro was first introduced.  It seems reasonable to think that they would follow a similar pattern but in reverse, essentially treating the conversion as a non-taxable event, while deferring any currency gain or loss until a subsequent disposition of the legacy currency.  Nevertheless, until taxpayers receive guidance from Treasury, the potential tax consequences of a eurozone breakup will remain one more area of uncertainty.

Treasury Finalizes New Debt Modification Regulations

January 10, 2011

By Jonathan Prokup

On Friday, the Treasury Department issued final regulations under Code section 1001 relating to the modification of debt instruments.  In relevant part, the regulation provides that, following the modification of a debt instrument, the classification of the modified instrument as debt or equity for federal income tax purposes does not take into account any deterioration in the financial condition of the obligor.  Treas. Reg. § 1.1001-3(f)(7)(ii)(A).

The only public comment on the proposed regulations noted that the existing regulation does not contain rules for determining whether a modified debt instrument remains debt for federal tax purposes.  As a result, the comment expressed concern that the regulation could be read to suggest that it would apply only “to determine whether an exchange has occurred, and not the determination of the character of a new instrument resulting from a significant modification.”  The final regulations add language to the general rule of Treas. Reg. § 1001-3(b) to make clear that the new rules apply to determine whether (i) an exchange has occurred and (ii) retains its prior characterization as debt for federal tax purposes.

As we previously discussed, absent this rule, holders of the debt of troubled obligors might be less willing to restructure the debt because of the risk of the restructuring being treated as an exchange, and therefore a recognition event, for federal income tax purposes.  If any financial deterioration of the obligor were taken into account, that factor could increase the risk that the debt would be recharacterized as something else following the modification.  Thus, the proposed regulations were a welcome (if incomplete) step to facilitating modifications of the debts of troubled obligors.

When Is Debt No Longer Debt? Treasury Proposes To Ease Debt-Modification Regulations

June 18, 2010

By Jonathan Prokup

Times are tough, and many troubled companies are facing the need to modify debts that were issued when times were better (and the companies were financially much stronger).  For companies that wish to modify their debts, and for investors that hold those debts, federal tax law imposes an unfortunate limitation.  An outstanding debt that undergoes a “significant modification” is treated as having been exchanged for a new instrument with the modified terms.  See Treas. Reg. § 1.1001-3.  As a result, holders of the debt will generally be required to recognize gain or loss on the deemed exchange of the debt and, in some instances, the issuer may be forced to recognize income as well.  Thus, the question of whether a modification will result in a deemed exchange of the debt for federal income tax purposes has the potential to complicate, or even derail, potentially beneficial debt modifications.


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