Note from the Editors
While the consensus appears to be that the world has stepped away from the abyss that threatened global financial markets and economies alike, the Internal Revenue Service ("IRS") and the U.S. Treasury Department ("Treasury") continue to be in crisis-response mode, addressing tax issues that arise from various stabilizing initiatives adopted by the U.S. government. Since the last issue of this publication, the IRS released Revenue Procedure 2009-37, which provides guidance on the Section 108(i)1 election that defers recognition of cancellation of indebtedness ("COD") income. The government also released Revenue Procedure 2009-38 and Revenue Procedure 2009-42, each of which addresses aspects of the Public- Private Investment Program ("PPIP"). In addition, the IRS provided favorable guidance on modifications of securitized commercial mortgage loans. This issue reports on these developments. We also report on developments unrelated to the credit crisis. The IRS released a favorable Chief Counsel Advice that addresses the taxation of trust preferred securities. In Schering-Plough Corp. v. United States, a U.S. district court disallowed perceived abusive tax benefits arising from an assignment of interest rate swaps by a domestic corporation to its foreign subsidiaries. And, responding to concerns that the oil markets are in part driven by speculation, Senator Wyden proposed a bill that would affect the taxation of certain actively traded oil and natural gas positions. Next, in a development that is in part driven by the global economic recovery that is believed currently to be underway, we have detected of late increasing activity on Wall Street relating to business development companies ("BDCs") and mortgage real estate investment trusts ("REITs"), each of which represents a structure for pooling capital to invest in targeted asset classes, including troubled businesses and distressed financial assets. In this issue, we compare and contrast the appeal and limitations of these two structures. Finally, in our regular feature, the Learning Annex, we provide a primer on the taxation of foreign-currency linked structured notes, a fast-growing segment of the structured products market.
1 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury regulations promulgated thereunder.
New Section 108(i) Guidance – An Executive Summary Section 108(i) was enacted on February 17, 2009.1 Where available, Section 108(i) permits taxpayers to elect to defer for a period of up to five years the recognition of COD income arising from repurchases, exchanges or modifications ("reacquisitions") of outstanding debt ("applicable debt instruments") that occur during 2009 and 2010. Under Section 108(i), if a debt instrument having original issue discount ("OID") is issued in exchange for an applicable debt instrument, deductions for the OID on the new instrument are disallowed during the deferral period to the extent such OID does not exceed the COD income realized but deferred in the exchange. After the expiration of the deferral period, the deferred OID deductions may be claimed ratably over the fiveyear period during which the COD income must be included.
On August 17, 2009, the IRS issued Revenue Procedure 2009-37, which, in addition to providing detailed administrative procedures for making the Section 108(i) election, clarifies certain ambiguities in the statute. Significantly, it also permits "partial elections" as discussed below. Here we provide a summary of some of the more important aspects of the new guidance.
Partial Elections. The revenue procedure makes clear that a taxpayer may make an election for all or any portion of COD income realized from the reacquisition of any applicable debt instrument. Thus, for example, if a taxpayer realizes $100 of COD income from the reacquisition of an applicable debt instrument, the taxpayer may elect to defer only $40 of the $100 of COD income. The remaining portion may be excluded under other Section 108 exceptions (e.g., the insolvency exception), if applicable. The procedure also clarifies that a taxpayer may make an election in respect of different portions of COD income arising from different applicable debt instruments (whether or not part of the same issue). In addition, a partnership that makes a partial election may specifically allocate the deferred amount to specific partners, allowing the partnership flexibility in tax planning for each partner.2
Pass-Through Entities. Under Section 108(i), certain events accelerate the deferral of COD income. These events include the death of, liquidation of, or other similar event with respect to, a taxpayer. In addition, certain dispositions of interests in partnerships, S corporations, or other "passthrough" entities cause acceleration. Importantly, clarifying an ambiguity in the statute, the revenue procedure provides that regulated investment companies ("RICs") and REITs are not pass-through entities for purposes of Section 108(i).
Impact on Earnings and Profits. The revenue procedure provides that the IRS intends to issue regulations that generally will provide that deferred COD income increases earnings and profits in the taxable year that it is realized and not in the taxable year or years that the deferred COD income is includible in gross income. OID deductions deferred under Section 108 generally will decrease earnings and profits in the taxable year or years in which the deduction would be allowed without regard to Section 108(i). However, in the case of RICs and REITs, COD income deferred under Section 108(i) generally increases earnings and profits in the taxable year or years in which the deferred COD income is includible in gross income and not in the year that the deferred COD income is realized and OID deductions deferred under Section 108(i) generally decrease earnings and profits in the taxable year or years that the deferred OID deductions are taken into account.
Transition Rules. A previous election that does not comply with the revenue procedure will not be effective unless the taxpayer files an amended return that complies with the requirements of the revenue procedure on or before November 16, 2009. In addition, a taxpayer that filed a Section 108(i) election on or before September 16, 2009 may modify that election by filing an amended return on or before November 16, 2009.
1 See our prior client alert at Temporary Deferral of Cancellation-of-Indebtedness Income Under the Recovery and Reinvestment Act of 2009 for a detailed discussion.
2 In the case of an entity classified for tax purposes as a partnership, COD income is recognized at the partnership level, but any applicable COD exclusions must be determined at the partner level.
IRS Lends Public-Private Investment Program a Helping Hand PPIP, unveiled on March 23, 2009, was designed to encourage the creation of markets for so-called "toxic assets" that were at the center of the credit crisis. It represents an effort to encourage the creation of investment funds, capitalized in part by the U.S. government and in part by private investors, to take toxic assets off the balance sheets of ailing financial institutions. The IRS has recently released favorable revenue procedures addressing two potential tax complications that funds, operating under PPIP, may face. The first prevents application of a rule that could impose an entity level tax on PPIP funds, and the second provides a favorable "look through" rule for testing whether a RIC that invests in such funds is adequately diversified for federal income tax purposes.
Revenue Procedure 2009-38, released on August 27, 2009, provides that the IRS will not assert that funds that invest in toxic assets under PPIP are "taxable mortgage pools" ("TMPs"). A TMP, treated as a corporation for federal income tax purposes that is subject to an entity level tax, generally is defined as any entity (other than a real estate mortgage investment conduit ("REMIC")) (i) substantially all of the assets of which consist of debt obligations and more than 50% of those assets are real estate mortgages, and (ii) that has issued multiple classes of debt, where the payments made on the debt issued are related to the payments received by the entity on its assets. The revenue procedure generally applies to a fund or portion of a fund that holds securities pursuant to PPIP, provided that the government owns a significant equity interest in the fund, and to any entity or portion of an entity that directly or indirectly owns equity interests in such a fund.
Revenue Procedure 2009-42, released on September 9, 2009, provides that, for purposes of meeting prescribed statutory asset diversification requirements,2 a RIC will be treated as if it directly invested in the assets held by the PPIP in...