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					Taxation of Financial Products and
Transactions

                      Policy
Practicing Law Institute -- Tax
Lessons From the Crash



                             Andrew Needham
                             Matthew Stevens
                               Michael Novey
                                Viva Hammer

                              January 26, 2011
             Disclaimer


ANY TAX ADVICE IN THIS COMMUNICATION IS NOT
INTENDED OR WRITTEN 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.
   Accrual of OID on Distressed Debt

X, an accrual method taxpayer, buys a $1000 distressed
bond for $200. On the date of original issue, the bond had
an issue price of $1000 and a 10% coupon. At the time of
purchase, X did not expect to collect more than $1000 on
the bond
Must X continue to include the 10% interest as it accrues?
No: an accrual method taxpayer has no obligation to report
stated interest of “doubtful collectibility”
But what if the bond paid interest at the same rate, but
either “in-kind” or at maturity?
  In TAM 9538007, the IRS concluded that the doubtful collectibility
  doctrine does not apply to OID
  Was it right?
What about the $800 of market discount?


                                                                   3
Accrual of Market Discount on Distressed
                  Debt
 Market discount is defined as the excess of the face
 amount of a debt instrument over the taxpayer’s
 basis in the debt
 Under the statute, therefore, X acquired the bond at a
 “market discount” of $800
 Assume that X ultimately collects $400 on the bond,
 realizing a $200 gain
 X must therefore report the $200 gain as ordinary
 income, but only to the extent of the accrued “market
 discount”
 So what portion of the $200 gain represents
 “accrued” market discount?
 Is any of it market discount?
                                                      4
Do the Market Discount Rules Even Apply
          to Distressed Debt?

No guidance from the IRS or Treasury. Must X
continue to include the 10% interest as it accrues?
  The 2010-2011 Priority Guidance Plan released in
  December by Treasury and the IRS includes “guidance
  relating to accruals of interest (including discount) on
  distressed debt”
Until then, we are left with …
  Common Law – “Doubtful collectibility” doctrine
  TAM 9538007
  Legislative History
What about common sense?



                                                             5
     The Economics of Debt Prices:
            Interest Rates

   Bond prices are sensitive to interest rates:
                 When interest rates go up…        $
           %               …Bond prices go down


• This is because the bond now pays interest at a “below
  market” rate, causing the price of the bond to fall.
 Similarly…        When interest rates go down…
          %                                        $
                             …Bond prices go up

 This is because the bond now pays interest at an “above
  market” rate, causing the price of the bond to rise

                                                           6
The Economics of Debt Prices: Financial
              Distress

But suppose that the discount arises not from an
increase in interest rates, but from a (severe) decline
in credit quality?
What happens to the price of a bond under these
conditions?
   Does it depend upon the bond’s maturity date?
   Does it depend upon the bond’s seniority within the
   capital structure?
Let’s look at some empirical data




                                                          7
              The Lehman Brothers Debacle in 2008

       Lehman Brothers bonds of every maturity converged to the same
       price, culminating in the largest bankruptcy in U.S. history




                               Lehman Brothers Bond Prices Leading Up to September 15, 2008 Bankruptcy

                         120

                         100

                         80
              Price($)




                         60

Bonds of
                         40
Different
Maturities:              20
       2010 Bond
                          0
       2017 Bond          5/15/2008   5/29/2008   6/12/2008    6/26/2008   7/10/2008   7/24/2008   8/7/2008   8/21/2008   9/4/2008

       2038 Bond
                                                              Period Preceding Bankruptcy Filing

                                                                                                                                     8
                                The Enron Debacle in 2001
     Enron bonds of every maturity converged to the same price,
     culminating in one of the largest bankruptcies in U.S. history




                                Enron Bond Prices Leading Up to December 3, 2001 Bankruptcy

                          120

                          100
              Price ($)




                          80

                          60
Bonds of
                          40
Different
Maturities:               20

     2003 Bond 0
     2005 Bond 7/31/01           8/14/01    8/28/01   9/11/01    9/25/01    10/9/01   10/23/01   11/6/01   11/20/01

     2028 Bond                                                                                                 BANKRUPT

                                                                                                                          9
                            The WorldCom Debacle in 2002

  WorldCom bonds of every maturity converged to within one
dollar, culminating in the next biggest bankruptcy in U.S. history



                                  WorldCom Bond Prices Leading Up to July 15, 2002 Bankruptcy

                            120


                            100


                            80
                Price ($)




                            60


                            40
  Bonds of
  Different
                            20
  Maturities:

      2003 Bond              0
                             1/31/02 2/14/02 2/28/02 3/14/02 3/28/02 4/11/02 4/25/02   5/9/02   5/23/02   6/6/02   6/20/02    7/4/02
      2005 Bond
      2031 Bond                                     Period Preceding Bankruptcy Filing
                                                                                                                             BANKRUPT
                                                                                                                                       10
                The Distress Anomaly
                             The 2 Year Bond   The 20 Year
                                                  Bond
Issue Price                        $1000          $1000
Rank                            Subordinated   Subordinated
Coupon                              4%             7%
“Revised” Issue Price              $500           $500
Nominal Yield                      79%            16%
Ultimate Settlement Amount         $700           $700

Total Gain                         $200           $200
  Interest component              $200            $8

  Capital gain component           $0            $192



                                                              11
 II. Cancellation of Indebtedness and
                AHYDO
Problem
 Debt market disrupted
   Market deteriorated suddenly. Trouble began in 2007, spiked
   in late 2008
   Thin trading
   Low market prices
   Spreads widened
      Government borrowing rates plummeted.
      Corporate borrowing rates skyrocketed, especially for issuers
      with lower credit ratings.
      TED Spread (3-mo. LIBOR to T-bill)
       » Hovered around 40 bp 2005-2006
       » Peaked at over 460 bp in October 2008




                                                                      12
II. Cancellation of Indebtedness and
               AHYDO
Problem (cont’d)
  Mark-to-market rules failing in many contexts.
  In tax context -
    Certain debt instruments valued according to market value
    where possible
    Valuation rules define market value broadly.
    Leads to inappropriate triggering of:
       Recognition of income under the cancellation of indebtedness
       (COD) rules; and
       Disallowance of OID deductions under rules for certain high-yield
       debt obligations (the AHYDO rules)




                                                                     13
 II. Cancellation of Indebtedness and
                AHYDO
Problem (cont’d)
 Virtually all bond trading done over-the-counter in privately
 negotiated transactions
   Prices traditionally not publicly reported
   Market less liquid than equity market
       About 80% of bonds did not trade in a typical month even before
       credit crisis
       Only 5% of outstanding par value traded in typical transaction.
       (Hotchkiss and Jostova, Determinants of Corporate Bond Trading:
       A Comprehensive Analysis, Working Paper, June 21, 2007)
       Most held by large institutions – about 40% of corporate bonds held
       by life insurance companies
       (Hotchkiss and Jostova, citing Hong and Warga, An Empirical
       Study of Corporate Bond Market Transactions, Financial Analysts
       Journal, 56, 32-46 (2000))
                                                                      14
  II. Cancellation of Indebtedness
         Income and AHYDO
Hypothetical
  Facts
  Borrower issues debt instrument for $100 million at 6% coupon, 7 yr
  term
     Borrower amends terms of debt after 6 months
         Trades 50 bp increase in interest rate for adjustments in covenants.
         Term and principal amount unchanged
     Minimum trading
        Current “bid” quotes for debt instrument listed on an electronic
        secondary market at 50 cents/dollar at time of amendment
        Little or no actual recent trading
  Tax treatment (pre and post Stimulus Act)
  Amendment is a “significant modification”
     Original debt instrument deemed exchanged for a new debt instrument.
     Borrower must recognize $50 million of COD income
     $50 million of offsetting OID deductions on new debt instrument are
     disallowed to issuer under AHYDO rules


                                                                            15
 II. Cancellation of Indebtedness and
                AHYDO
Law: Issue Price
 Issue price is how the tax law values a debt
   Debt instruments issued for cash: Issue price is first price at
   which a substantial amount of the debt is sold for money
      IP of original debt instrument = $100 million
      See Regulations § 1.1273-2(a)
   Debt instruments issued for property: Law looks for market
   price if either the new or old debt instruments are “publicly
   traded”
      IP of new debt instrument = $50 million
      See Regulations § 1.1273-2(b)
   Law provides different valuation mechanism under IRC
   Section 1274 if there is no public trading and certain other
   conditions apply
                                                                   16
 II. Cancellation of Indebtedness and
                AHYDO

Law: Issue Price (cont’d)
 “Publicly Traded Property” is defined broadly. See
 Regulations § 1.1273-2(b)
   Exchange listed, e.g., listed on a national securities exchange
   Market traded, e.g., traded on an interbank market
   Appears on a quotation medium
      Includes a computer listing disseminated to subscribing brokers, dealers,
      or traders containing recent price quotes, e.g., Market
      Craig’s List for debt instruments?
   Readily quotable, i.e., price quotes readily available from dealers,
   brokers or traders



                                                                             17
 II. Cancellation of Indebtedness and
                AHYDO
Law: Issue Price (cont’d)
 Proposed regulations defining “Publicly Traded Property” were
 issued on January 6, 2011 under Regulations § 1.1273-2(f)
    Exchange listed, e.g., listed on a national securities exchange
    Sales price of an executed purchase or sale is reasonably
    available
    Firm quotes
      Price quote is available from at least one broker, dealer or pricing
      service
      Quoted price is substantially the same as the price at which it
      could be sold
      The identity of the party providing the quote must be reasonably
      ascertainable
   Indicative Quotes
      Price quote is available from at least one broker, dealer or pricing
      service and the quote is not a firm quote

                                                                        18
 II. Cancellation of Indebtedness and
                AHYDO

Law: Issue Price (cont’d)
 New de-minimis trading rule:
    Each trade during the relevant 31 day period is for amounts less
    than $1 million and the aggregate amount of such trades does
    not exceed $5 million
 Small debt issue exception:
    Property is not treated as traded on an established market if the
    original stated principal amount of the issue does not exceed
    $50 million




                                                                19
II. Cancellation of Indebtedness Income
               and AHYDO

Law: Debt Modifications. See Regulations § 1.1001-3(b) and
(e)
   Significant modification of a debt instrument is treated as an
   exchange of the original debt instrument for a new debt
   instrument.
   Low threshold for “significant” modification
   Does not distinguish between an increase or decrease in the
   borrower’s burden
   Examples (non-exclusive list):
     Change in interest rate (up or down); and
     Change in principal amount (up or down)
  Is it debt?
     Final regulations issued under section 1.1001-3(f) in 2011 addressing when a
     taxpayer’s financial deterioration should be considered to determine whether
     a modification results in something that is not debt for tax purposes. T.D.
     9513

                                                                             20
  II. Cancellation of Indebtedness and
                 AHYDO
Deemed Exchange

If a debtor satisfies a debt obligation by issuing a new
debt instrument, then treated as satisfying the old debt
with a payment equal to the issue price of the new debt.
See IRC Section 108(e)(10)
COD Income
Issuer recognizes COD income upon repurchase of a
debt instrument for an amount less than its adjusted
issue price. See Regulations § 1.61-12(c)(2)(ii)


                                                       21
 II. Cancellation of Indebtedness and
                AHYDO

Example: COD
  Facts
   $100 million debt
   Covenants are modified in return for 50 bp increase in interest rate
   Modified debt trades at 50% of face on thin secondary market
 Issue Price
   Old debt: $100 million, measured by cash proceeds
   New debt: $50 million, measured by market quote
 COD: IP of old debt minus IP of new debt = $50
 million
 Result: Debtor is taxed as if it received $50 million of
 income, even though its obligation under the debt
 instrument was increased in the transaction.

                                                                          22
 II. Cancellation of Indebtedness and
                AHYDO

Law: AHYDO. See IRC Sections 163(i) and (e)(5)
 AHYDO Definition
   Term greater than 5 years
   Yield greater than AFR + 5%
   “Significant OID”
 AHYDO Rules
   Portion of OID disallowed as a deduction to the issuer.
      Disallowed portion can easily reach 100% of total OID because based on
      AFR plus 6%
      COD inclusion not reduced due to disallowed deductions for OID created
      by same transaction
   Remaining OID only deductible when paid
   Increases timing mis-match between the COD and OID created by
   the same transaction

                                                                          23
II. Cancellation of Indebtedness and
                AHYDO
Example: AHYDO Definition
  Facts
   Borrower issues debt instrument for $100 million at 6% coupon,
   7 yr term
   Borrower amends terms of debt after 6 months
      Trades 50 bp increase in interest rate for adjustments in
      covenants.
      Term and principal amount unchanged
   Minimum trading
      Current “bid” quotes for debt instrument listed on an
      electronic secondary market at 50 cents/dollar at time of
      amendment
      Little or no actual recent trading


                                                              24
II. Cancellation of Indebtedness and
                AHYDO
 Example: AHYDO Definition (cont’d)
  New debt instrument is an AHYDO
    Term of 6.5 years is greater than 5 years
    Yield of 21% is greater than AFR plus 5%
       Yield calculated from new issue price
       Current AFR is 1.92%, so bar is now at 6.92%.
    Significant OID
       OID = SRPM minus IP = $50 million
       Test in IRC Section 163(i)(2), in essence, compares the OID
       accrued after 5 years to the IP x Yield to determine whether OID
       is “significant”
    Note on Issue Price - Both the high yield and high OID are a direct
    result of the low market-based issue price




                                                                    25
II. Cancellation of Indebtedness and
                AHYDO
Example: AHYDO Definition (cont’d)
 Disqualified portion. See IRC Section 163(e)(5)(C)
    Total return x (disqualified yield / yield)
      Total return is OID plus Qualified Stated Interest (QSI)
      Disqualified yield = yield minus (AFR + 6%)
      Capped at total amount of OID
    Example
      OID = $50 million. Total Return ($92 million) minus QSI
      ($42 million)
      Yield = 21%, disqualified yield = 13%
      Disqualified portion = $92 million x (13/21) = $57 million,
      but capped at $50 million (total OID)




                                                                    26
II. Cancellation of Indebtedness and
               AHYDO
Example: AHYDO Definition (cont’d)
 Result:
    Debtor realizes $50M in COD income;
    Debtor allowed $0 offsetting OID deductions; and
    Debtor owes same principal amount, over same term, at a
    higher interest rate
 Reason: Issue price re-set to value of low market
 quote because of the debt modification




                                                              27
II. Cancellation of Indebtedness and
               AHYDO
Interaction of Rules
  COD normally offset by OID deductions
    COD = IP(old) minus IP(new) = $50 million
    OID = SRPM minus IP(new) = $50 million
    Imperfect offset because of timing difference
  This offset disrupted by the AHYDO rules
    Disallows some or all of the OID deductions that correspond
    to the COD inclusion
    Any remaining OID deductions deferred
       Remainder deductible when paid (instead of when accrued)
       Worsens original timing difference between COD inclusion and
       OID deductions




                                                                      28
II. Cancellation of Indebtedness and
                AHYDO
 Interaction of Rules (cont’d)
   Are results unintended?
     COD meant to tax economic gain from being relieved of a debt.
     AHYDO meant to reclassify excess OID on certain equity-like
     securities as dividends
   Real-world consequences
     COD creating large, unexpected income inclusions.
     Can create immediate cash tax liability if issuer does not have
     enough NOLs to offset the COD income
     Even issuers in serious financial trouble today have not necessarily
     built up sufficient NOLs to offset a sudden COD income inclusion
     from a debt modification




                                                                       29
II. Cancellation of Indebtedness and
               AHYDO
American Recovery & Reinvestment Act of 2009
(Stimulus Act)
  Election to defer recognition of COD, effective for transactions
  in 2009 and 2010 only. Does not apply to transactions
  occurring in 2011
    Recognize COD over 5-year period, beginning in 2014.
    Must also defer corresponding OID deductions to match COD
    inclusions with OID deductions
    Applies to COD from debt reacquisitions.
        By issuer or related person
        For cash, new debt, or corporate stock or partnership interest if debt
        contributed to capital
        Includes debt modifications
        Includes complete forgiveness of debt by holder.
    Available for -
        Debt issued by a C corporation (or other person if connected with a
        trade or business of that person)
        Debt issued in 2009 or 2010



                                                                                 30
II. Cancellation of Indebtedness and
               AHYDO
 American Recovery & Reinvestment Act of 2009 (Stimulus Act)
 (cont’d)
   AHYDO rules suspended for -
     New debt issued in exchange for old debt
        In debt-for-debt exchange (or modification)
        Old debt not an AHYDO
        After August 31, 2008 or in 2009
        »     Notice 2010-11 extended the AHYDO suspension for new debt
              issued during 2010. No extension for 2011 so far.
        No change in obligor, no contingent portfolio interest, no debts issued to
        related persons
      Subsequent exchanges with same effective dates.
   Treasury granted authority to -
     Extend suspension of AHYDO rules into the future
     Temporarily substitute a higher rate for the AFR in the definition of AHYDO
     after 2009
     Both permitted if conditions in the debt capital markets continue to be
     distressed


                                                                                31
II. Cancellation of Indebtedness and
               AHYDO
Open Questions on the Proposed Regulations
Defining “Publicly Traded”
  The de minimis trading exception refers to “trades,” does this
  mean that only actual trades are taken into account? In the
  context of a debt modification, is the deemed acquisition a
  “trade” for these purposes?
  The FMV of a debt instrument is presumed to be equal to its
  traded price, sales price or quoted price. If more than one
  traded price, sales price or quoted price is available, a taxpayer
  may use any reasonable method, consistently applied, to
  determine the price
     Is this presumption irrebutable for debt instruments for which only
     one price is available?
     How does this rule compare with the special rule for property for
     which there is only an indicative quote?

                                                                      32
II. Cancellation of Indebtedness and
               AHYDO
Summary
 Debt modifications trigger COD and AHYDO rules
   Tax rules value debt according to market value where possible
   Market values plummeted suddenly due to disruption in credit
   markets
   Debtors surprised by tax effects
 Temporary relief available for transactions occurring
 in 2009 or 2010
   Will this temporary relief be extended for 2011?
 Opportunity to craft permanent fixes




                                                               33
  International Aspects of Financial
             Transactions

Broaden portfolio interest deduction
Expansion of section 956




                                       34
Expansion of portfolio interest exemption
         from withholding tax

Current limitations are substantial:
  Must be unrelated parties (even a 10% shareholder
  cannot receive interest free of U.S. withholding tax)
  Must not be “received by a bank on an extension of
  credit made pursuant to a loan agreement entered into
  in the ordinary course of its trade or business”
  Must not be subject to certain contingencies




                                                     35
Expansion of portfolio interest exemption
         from withholding tax

Does the limitation to unrelated parties make sense
(e.g., why not let a non-U.S. person hold convertible
debt)?
Even if it generally makes sense, should it be relaxed
(e.g., to more than 50% share ownership)?




                                                     36
Expansion of portfolio interest exemption
         from withholding tax

 What about the exclusion for banks?
   More a regulatory concern than a tax concern
   Was this ever justified?
   Does it make sense to force the banks to originate the
   loans, and then sell them to hedge funds?




                                                        37
Expansion of portfolio interest exemption
         from withholding tax
 How about contingent interest?
   This one probably makes more sense, because
   justified in terms of avoiding quasi-dividend payments,
   unless . . . .
   Congress adopts a “portfolio dividend” provision




                                                        38
   Expansion of portfolio interest
   exemption from withholding tax

What about a portfolio dividend provision (at least for
dividends paid on certain types of equity)?
   Only preferred stock?
   Also common stock?
Should a portfolio dividend provision replace the
portfolio interest exemption?




                                                      39
        Pledge of CFC Stock                                  Multiple Inclusions Exceed
                                                               Borrowing
                                                                                $1000                 U.S.
                          U.S.                                    Lender                            Borrower
Lender      $1000
                        Borrower

                                                                         “Deemed                                         ““Deemed
    “Deemed                                                              Dividend”                                       Dividend”
                                                                         of $1000                                         of $1000
    Dividend”                          Stock Pledge
    of $1000                                                                         CFC                              CFC
                          CFC                                                  (E&P = $1000)                     (E&P = $1000)
                       (E&P = $1000)




                                                                              GUARANTEE                        GUARANTEE


        Loan Exceeds FMV of CFC                               Loan Exceeds FMV of Pledged Asset
            $1000
Lender                U.S. Borrower                                           $1000
                                                                Lender                              U.S. Borrower


                                       “Deemed Dividend”                 “Deemed Dividend”
          Guarantee                        of $1000                          of $1000
                           CFC                                                                           CFC
                                                                                                      (E&P = $1000)

                                                                 Pledge
                         Assets
                                                                   of
                                                                                           Assets                     Assets
                                                               $100 Asset

                      FMV = $500                                                FMV = $100                       FMV = $2000
                      E&P = $1000

                                                                                                                                 40
                   Derivatives

Major issues
  Credit derivatives
  Dodd-Frank
Secondary issues




                                 41
                   Derivatives

Credit Default Swaps
  TRS and other credit derivatives all converged in
  CDS
  Need for regulating CDS
    Self regulation – big bang
    Federal govt. regulation – Dodd-Frank
  Tax treatment
    Never settled prior to Dodd-Frank, several approaches
    Post Dodd-Frank with clearinghouses and standardization




                                                              42
                   Derivatives
CDS Clearinghouse Operations
 Clearinghouse Corporation/Intercontinental Exchange
 Clearinghouse
   Regulated by New York banking department and Federal
   Reserve
   Trades negotiated OTC, then submitted to clearinghouse
   Clearinghouse becomes sole counterparty; daily netting occurs.
   Index contracts only initially
   Participants currently limited to banks and broker-dealers.
 Chicago Mercantile Exchange/Citadel Exchange and
 Clearinghouse
   Trades entered into on exchange
   Otherwise expected to function similarly
 European Clearinghouse
   Liffe/LCH-Clearnet Clearinghouse (launched December 2008).
   NYSE Euronext/Eurex Clearinghouse                                43
                Derivatives

Tax Issues
 Clearinghouse is not an exchange
   Effect on insurance/guarantee vs. derivative issue
   Effect on pending timing rules?
 Is clearinghouse an exchange for purposes of
 section 1256?
   Possible mismatch in character and timing with hedges (mixed
   straddles)
   Competitive (dis)advantage vs. non-exchange CDSs?
   What happens if CDS is cleared in mid-life?
 Last page of Dodd-Frank and effect on swaps not
 mentioned there


                                                                  44
                   Derivatives


Secondary issues
  Mark to market for a broader class of instruments
  Accrual of income on prepaid forwards
  Nonrecognition of gain or loss on securities loans




                                                       45

				
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