Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011

Taxation of Financial Products and Transactions

Practicing Law Institute -- Tax Policy Lessons From the Crash

Taxation of Financial Products and Transactions

Practicing Law Institute -- Tax Policy Lessons From the Crash

Andrew NeedhamAndrew NeedhamMatthew StevensMatthew Stevens

Michael NoveyMichael NoveyViva HammerViva Hammer

January 26, 2011

DisclaimerDisclaimer

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.MATTERS ADDRESSED HEREIN.

3

Accrual of OID on Distressed DebtAccrual of OID on Distressed Debt

X, an accrual method taxpayer, buys a $1000 distressed X, an accrual method taxpayer, buys a $1000 distressed bond for $200. On the date of original issue, the bond had 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 an issue price of $1000 and a 10% coupon. At the time of purchase, X did not expect to collect more than $1000 on purchase, X did not expect to collect more than $1000 on the bondthe bondMust X continue to include the 10% interest as it accrues?Must X continue to include the 10% interest as it accrues?No: an accrual method taxpayer has no obligation to report No: an accrual method taxpayer has no obligation to report stated interest of “doubtful collectibility”stated interest of “doubtful collectibility”But what if the bond paid interest at the same rate, but But what if the bond paid interest at the same rate, but either “in-kind” or at maturity?either “in-kind” or at maturity?

In TAM 9538007, the IRS concluded that the doubtful collectibility In TAM 9538007, the IRS concluded that the doubtful collectibility doctrine does not apply to OIDdoctrine does not apply to OIDWas it right?Was it right?

What about the $800 of market discount?What about the $800 of market discount?

4

Accrual of Market Discount on Distressed Debt

Accrual of Market Discount on Distressed Debt

Market discount is defined as the excess of the face Market discount is defined as the excess of the face amount of a debt instrument over the taxpayer’s amount of a debt instrument over the taxpayer’s basis in the debtbasis in the debtUnder the statute, therefore, X acquired the bond at a Under the statute, therefore, X acquired the bond at a “market discount” of $800“market discount” of $800Assume that X ultimately collects $400 on the bond, Assume that X ultimately collects $400 on the bond, realizing a $200 gainrealizing a $200 gainX must therefore report the $200 gain as ordinary X must therefore report the $200 gain as ordinary income, but income, but onlyonly to the extent of the accrued “market to the extent of the accrued “market discount”discount”So what portion of the $200 gain represents So what portion of the $200 gain represents “accrued” market discount?“accrued” market discount?Is Is anyany of it market discount? of it market discount?

5

Do the Market Discount Rules Even Apply to Distressed Debt?

Do the Market Discount Rules Even Apply to Distressed Debt?

No guidance from the IRS or Treasury. Must X continue No guidance from the IRS or Treasury. Must X continue to include the 10% interest as it accrues?to include the 10% interest as it accrues?

The 2010-2011 Priority Guidance Plan released in The 2010-2011 Priority Guidance Plan released in December by Treasury and the IRS includes “guidance December by Treasury and the IRS includes “guidance relating to accruals of interest (relating to accruals of interest (including discountincluding discount) on ) on distressed debt”distressed debt”

Until then, we are left with …Until then, we are left with …Common Law – “Doubtful collectibility” doctrineCommon Law – “Doubtful collectibility” doctrineTAM 9538007TAM 9538007Legislative HistoryLegislative History

What about common sense?What about common sense?

6

The Economics of Debt Prices: Interest Rates

The Economics of Debt Prices: Interest Rates

Bond prices are sensitive to 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

7

The Economics of Debt Prices: Financial Distress

The Economics of Debt Prices: Financial Distress

But suppose that the discount arises not from an But suppose that the discount arises not from an increase in interest rates, but from a (severe) decline increase in interest rates, but from a (severe) decline in credit quality?in credit quality?What happens to the price of a bond under these What happens to the price of a bond under these conditions?conditions?

Does it depend upon the bond’s maturity date?Does it depend upon the bond’s maturity date?Does it depend upon the bond’s seniority within the Does it depend upon the bond’s seniority within the capital structure?capital structure?

Let’s look at some empirical dataLet’s look at some empirical data

8

The Lehman Brothers Debacle in 2008The Lehman Brothers Debacle in 2008

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

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

0

20

40

60

80

100

120

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

Period Preceding Bankruptcy Filing

Pri

ce($

)

2010 Bond

2017 Bond

2038 Bond

Bonds of Different Maturities:

9

The Enron Debacle in 2001The Enron Debacle in 2001

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

Enron Bond Prices Leading Up to December 3, 2001 Bankruptcy

0

20

40

60

80

100

120

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

Pri

ce (

$)

2003 Bond

2005 Bond

2028 Bond BANKRUPT


10

The WorldCom Debacle in 2002The WorldCom Debacle in 2002

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

WorldCom Bond Prices Leading Up to July 15, 2002 Bankruptcy

0

20

40

60

80

100

120

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

Period Preceding Bankruptcy Filing

Pri

ce (

$)

2003 Bond

2005 Bond

2031 Bond


BANKRUPT

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The Distress AnomalyThe 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

12

ProblemProblem

Debt market disruptedDebt market disruptedMarket deteriorated suddenly. Trouble began in 2007, spiked Market deteriorated suddenly. Trouble began in 2007, spiked in late 2008in late 2008Thin tradingThin tradingLow market pricesLow market pricesSpreads widenedSpreads widened

Government borrowing rates plummeted.Government borrowing rates plummeted.Corporate borrowing rates skyrocketed, especially for issuers Corporate borrowing rates skyrocketed, especially for issuers with lower credit ratings.with lower credit ratings.TED Spread (3-mo. LIBOR to T-bill)TED Spread (3-mo. LIBOR to T-bill)» Hovered around 40 bp 2005-2006Hovered around 40 bp 2005-2006» Peaked at over 460 bp in October 2008Peaked at over 460 bp in October 2008

II. Cancellation of Indebtedness and AHYDO


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Problem (cont’d)Problem (cont’d)

Mark-to-market rules failing in many contexts.Mark-to-market rules failing in many contexts.In tax context -In tax context -

Certain debt instruments valued according to market value Certain debt instruments valued according to market value where possiblewhere possibleValuation rules define market value broadly.Valuation rules define market value broadly.Leads to inappropriate triggering of: Leads to inappropriate triggering of:

Recognition of income under the cancellation of indebtedness Recognition of income under the cancellation of indebtedness (COD) rules; and(COD) rules; andDisallowance of OID deductions under rules for certain high-yield Disallowance of OID deductions under rules for certain high-yield debt obligations (the AHYDO rules)debt obligations (the AHYDO rules)

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Problem (cont’d)Problem (cont’d)Virtually all bond trading done over-the-counter in privately Virtually all bond trading done over-the-counter in privately negotiated transactionsnegotiated transactions

Prices traditionally not publicly reportedPrices traditionally not publicly reported

Market less liquid than equity marketMarket less liquid than equity market

About 80% of bonds did not trade in a typical month even before About 80% of bonds did not trade in a typical month even before credit crisiscredit crisis

Only 5% of outstanding par value traded in typical transaction.Only 5% of outstanding par value traded in typical transaction.(Hotchkiss and Jostova, Determinants of Corporate Bond Trading: (Hotchkiss and Jostova, Determinants of Corporate Bond Trading: A Comprehensive Analysis, Working Paper, June 21, 2007)A Comprehensive Analysis, Working Paper, June 21, 2007)

Most held by large institutions – about 40% of corporate bonds held Most held by large institutions – about 40% of corporate bonds held by life insurance companiesby life insurance companies(Hotchkiss and Jostova, citing Hong and Warga, An Empirical Study (Hotchkiss and Jostova, citing Hong and Warga, An Empirical Study of Corporate Bond Market Transactions, of Corporate Bond Market Transactions, Financial Analysts JournalFinancial Analysts Journal, , 56, 32-46 (2000))56, 32-46 (2000))

15

HypotheticalHypothetical

FactsFactsBorrower issues debt instrument for $100 million at 6% coupon, 7 yr Borrower issues debt instrument for $100 million at 6% coupon, 7 yr termterm

Borrower amends terms of debt after 6 monthsBorrower amends terms of debt after 6 monthsTrades 50 bp increase in interest rate for adjustments in covenants.Trades 50 bp increase in interest rate for adjustments in covenants.Term and principal amount unchangedTerm and principal amount unchanged

Minimum tradingMinimum tradingCurrent “bid” quotes for debt instrument listed on an electronic Current “bid” quotes for debt instrument listed on an electronic secondary market at 50 cents/dollar at time of amendmentsecondary market at 50 cents/dollar at time of amendmentLittle or no actual recent tradingLittle or no actual recent trading

Tax treatment (pre and post Stimulus Act)Tax treatment (pre and post Stimulus Act) Amendment is a “significant modification”Amendment is a “significant modification”

Original debt instrument deemed exchanged for a new debt instrument.Original debt instrument deemed exchanged for a new debt instrument.Borrower must recognize $50 million of COD incomeBorrower must recognize $50 million of COD income$50 million of offsetting OID deductions on new debt instrument are $50 million of offsetting OID deductions on new debt instrument are disallowed to issuer under AHYDO rulesdisallowed to issuer under AHYDO rules

II. Cancellation of Indebtedness Income and AHYDO


16

Law: Issue PriceLaw: Issue Price

Issue price is how the tax law values a debtIssue price is how the tax law values a debtDebt instruments issued for cash: Issue price is first price at Debt instruments issued for cash: Issue price is first price at which a substantial amount of the debt is sold for moneywhich a substantial amount of the debt is sold for money

IP of original debt instrument = $100 millionIP of original debt instrument = $100 million

See Regulations § 1.1273-2(a)See Regulations § 1.1273-2(a)

Debt instruments issued for property: Law looks for market Debt instruments issued for property: Law looks for market price if either the new or old debt instruments are “publicly price if either the new or old debt instruments are “publicly traded”traded”

IP of new debt instrument = $50 millionIP of new debt instrument = $50 million

See Regulations § 1.1273-2(b)See Regulations § 1.1273-2(b)

Law provides different valuation mechanism under IRC Law provides different valuation mechanism under IRC Section 1274 if there is no public trading and certain other Section 1274 if there is no public trading and certain other conditions applyconditions apply



17

Law: Issue Price (cont’d)Law: Issue Price (cont’d)

““Publicly Traded Property” is defined broadly. See Publicly Traded Property” is defined broadly. See Regulations § 1.1273-2(b)Regulations § 1.1273-2(b)

Exchange listed, e.g., listed on a national securities exchangeExchange listed, e.g., listed on a national securities exchange

Market traded, e.g., traded on an interbank marketMarket traded, e.g., traded on an interbank market

Appears on a quotation mediumAppears on a quotation medium

Includes a computer listing disseminated to subscribing brokers, dealers, Includes a computer listing disseminated to subscribing brokers, dealers, or traders containing recent price quotes, e.g., Marketor traders containing recent price quotes, e.g., Market

Craig’s List for debt instruments?Craig’s List for debt instruments?

Readily quotable, i.e., price quotes readily available from dealers, Readily quotable, i.e., price quotes readily available from dealers, brokers or tradersbrokers or traders



18

Law: Issue Price (cont’d)Law: Issue Price (cont’d)Proposed regulations defining “Publicly Traded Property” were Proposed regulations defining “Publicly Traded Property” were issued on January 6, 2011 under Regulations § 1.1273-2(f)issued on January 6, 2011 under Regulations § 1.1273-2(f)

Exchange listed, e.g., listed on a national securities exchangeExchange listed, e.g., listed on a national securities exchangeSales price of an executed purchase or sale is reasonably Sales price of an executed purchase or sale is reasonably availableavailableFirm quotesFirm quotes

Price quote is available from at least one broker, dealer or pricing Price quote is available from at least one broker, dealer or pricing service service Quoted price is substantially the same as the price at which it Quoted price is substantially the same as the price at which it could be soldcould be soldThe identity of the party providing the quote must be reasonably The identity of the party providing the quote must be reasonably ascertainableascertainable

Indicative QuotesIndicative QuotesPrice quote is available from at least one broker, dealer or pricing Price quote is available from at least one broker, dealer or pricing service and the quote is not a firm quoteservice and the quote is not a firm quote



19



Law: Issue Price (cont’d)Law: Issue Price (cont’d)

New de-minimis trading rule:New de-minimis trading rule:Each trade during the relevant 31 day period is for amounts Each trade during the relevant 31 day period is for amounts less than $1 million and the aggregate amount of such trades less than $1 million and the aggregate amount of such trades does not exceed $5 milliondoes not exceed $5 million

Small debt issue exception: Small debt issue exception: Property is not treated as traded on an established market if the Property is not treated as traded on an established market if the original stated principal amount of the issue does not exceed original stated principal amount of the issue does not exceed $50 million$50 million

20

Law: Debt Modifications. See Regulations § 1.1001-3(b) and Law: Debt Modifications. See Regulations § 1.1001-3(b) and (e)(e)

Significant modification of a debt instrument is treated as an Significant modification of a debt instrument is treated as an exchange of the original debt instrument for a new debt exchange of the original debt instrument for a new debt instrument.instrument.Low threshold for “significant” modification Low threshold for “significant” modification Does not distinguish between an increase or decrease in the Does not distinguish between an increase or decrease in the borrower’s burdenborrower’s burdenExamples (non-exclusive list):Examples (non-exclusive list):

Change in interest rate (up or down); andChange in interest rate (up or down); andChange in principal amount (up or down)Change in principal amount (up or down)

Is it debt?Is it debt?Final regulations issued under section 1.1001-3(f) in 2011 addressing when a Final regulations issued under section 1.1001-3(f) in 2011 addressing when a taxpayer’s financial deterioration should be considered to determine whether taxpayer’s financial deterioration should be considered to determine whether a modification results in something that is not debt for tax purposes. T.D. a modification results in something that is not debt for tax purposes. T.D. 95139513



21

Deemed ExchangeDeemed Exchange

If a debtor satisfies a debt obligation by issuing a new If a debtor satisfies a debt obligation by issuing a new debt instrument, then treated as satisfying the old debt debt instrument, then treated as satisfying the old debt with a payment equal to the issue price of the new debt. with a payment equal to the issue price of the new debt. See IRC Section 108(e)(10)See IRC Section 108(e)(10)

COD IncomeCOD Income

Issuer recognizes COD income upon repurchase of a Issuer recognizes COD income upon repurchase of a debt instrument for an amount less than its adjusted debt instrument for an amount less than its adjusted issue price. See Regulations § 1.61-12(c)(2)(ii) issue price. See Regulations § 1.61-12(c)(2)(ii)



22

Example: CODExample: COD

Facts Facts $100 million debt$100 million debtCovenants are modified in return for 50 bp increase in interest rateCovenants are modified in return for 50 bp increase in interest rateModified debt trades at 50% of face on thin secondary marketModified debt trades at 50% of face on thin secondary market

Issue Price Issue Price Old debt: $100 million, measured by cash proceedsOld debt: $100 million, measured by cash proceedsNew debt: $50 million, measured by market quoteNew debt: $50 million, measured by market quote

COD: IP of old debt minus IP of new debt = $50 COD: IP of old debt minus IP of new debt = $50 millionmillionResult: Debtor is taxed as if it received $50 million of Result: Debtor is taxed as if it received $50 million of income, even though its obligation under the debt income, even though its obligation under the debt instrument was increased in the transaction.instrument was increased in the transaction.



23

Law: AHYDO. See IRC Sections 163(i) and (e)(5)Law: AHYDO. See IRC Sections 163(i) and (e)(5)

AHYDO DefinitionAHYDO DefinitionTerm greater than 5 yearsTerm greater than 5 yearsYield greater than AFR + 5%Yield greater than AFR + 5%““Significant OID”Significant OID”

AHYDO RulesAHYDO RulesPortion of OID disallowed as a deduction to the issuer.Portion of OID disallowed as a deduction to the issuer.

Disallowed portion can easily reach 100% of total OID because based on Disallowed portion can easily reach 100% of total OID because based on AFR plus 6%AFR plus 6%COD inclusion not reduced due to disallowed deductions for OID created COD inclusion not reduced due to disallowed deductions for OID created by same transactionby same transaction

Remaining OID only deductible when paidRemaining OID only deductible when paidIncreases timing mis-match between the COD and OID created by Increases timing mis-match between the COD and OID created by the same transactionthe same transaction



24

Example: AHYDO DefinitionExample: AHYDO Definition

FactsFactsBorrower issues debt instrument for $100 million at 6% coupon, Borrower issues debt instrument for $100 million at 6% coupon, 7 yr term7 yr termBorrower amends terms of debt after 6 monthsBorrower amends terms of debt after 6 months

Trades 50 bp increase in interest rate for adjustments in Trades 50 bp increase in interest rate for adjustments in covenants.covenants.Term and principal amount unchangedTerm and principal amount unchanged

Minimum tradingMinimum tradingCurrent “bid” quotes for debt instrument listed on an Current “bid” quotes for debt instrument listed on an electronic secondary market at 50 cents/dollar at time of electronic secondary market at 50 cents/dollar at time of amendmentamendmentLittle or no actual recent trading Little or no actual recent trading



25

Example: AHYDO Definition (cont’d)Example: AHYDO Definition (cont’d)

New debt instrument is an AHYDONew debt instrument is an AHYDOTerm of 6.5 years is greater than 5 years Term of 6.5 years is greater than 5 years Yield of 21% is greater than AFR plus 5% Yield of 21% is greater than AFR plus 5%

Yield calculated from new issue priceYield calculated from new issue priceCurrent AFR is 1.92%, so bar is now at 6.92%.Current AFR is 1.92%, so bar is now at 6.92%.

Significant OID Significant OID OID = SRPM minus IP = $50 millionOID = SRPM minus IP = $50 millionTest in IRC Section 163(i)(2), in essence, compares the OID 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 accrued after 5 years to the IP x Yield to determine whether OID is “significant”is “significant”

Note on Issue Price - Both the high yield and high OID are a direct Note on Issue Price - Both the high yield and high OID are a direct result of the low market-based issue priceresult of the low market-based issue price



26

Example: AHYDO Definition (cont’d)Example: AHYDO Definition (cont’d)Disqualified portion. See IRC Section 163(e)(5)(C)Disqualified portion. See IRC Section 163(e)(5)(C)

Total return x (disqualified yield / yield)Total return x (disqualified yield / yield)Total return is OID plus Qualified Stated Interest (QSI) Total return is OID plus Qualified Stated Interest (QSI) Disqualified yield = yield minus (AFR + 6%)Disqualified yield = yield minus (AFR + 6%)Capped at total amount of OIDCapped at total amount of OID

Example Example OID = $50 million. Total Return ($92 million) minus QSI OID = $50 million. Total Return ($92 million) minus QSI ($42 million)($42 million)Yield = 21%, disqualified yield = 13%Yield = 21%, disqualified yield = 13%Disqualified portion = $92 million x (13/21) = $57 million, Disqualified portion = $92 million x (13/21) = $57 million, but capped at $50 million (total OID) but capped at $50 million (total OID)



27

Example: AHYDO Definition (cont’d)Example: AHYDO Definition (cont’d)Result:Result:

Debtor realizes $50M in COD income;Debtor realizes $50M in COD income;Debtor allowed $0 offsetting OID deductions; andDebtor allowed $0 offsetting OID deductions; andDebtor owes same principal amount, over same term, at a Debtor owes same principal amount, over same term, at a higher interest ratehigher interest rate

Reason: Issue price re-set to value of low market Reason: Issue price re-set to value of low market quote because of the debt modificationquote because of the debt modification



28

Interaction of RulesInteraction of RulesCOD normally offset by OID deductionsCOD normally offset by OID deductions

COD = IP(old) minus IP(new) = $50 millionCOD = IP(old) minus IP(new) = $50 millionOID = SRPM minus IP(new) = $50 millionOID = SRPM minus IP(new) = $50 millionImperfect offset because of timing differenceImperfect offset because of timing difference

This offset disrupted by the AHYDO rulesThis offset disrupted by the AHYDO rulesDisallows some or all of the OID deductions that correspond Disallows some or all of the OID deductions that correspond to the COD inclusionto the COD inclusionAny remaining OID deductions deferredAny remaining OID deductions deferred

Remainder deductible when paid (instead of when accrued)Remainder deductible when paid (instead of when accrued)Worsens original timing difference between COD inclusion and Worsens original timing difference between COD inclusion and OID deductionsOID deductions



29

Interaction of Rules (cont’d)Interaction of Rules (cont’d)

Are results unintended?Are results unintended? COD meant to tax economic gain from being relieved of a debt.COD meant to tax economic gain from being relieved of a debt.AHYDO meant to reclassify excess OID on certain equity-like AHYDO meant to reclassify excess OID on certain equity-like securities as dividendssecurities as dividends

Real-world consequencesReal-world consequencesCOD creating large, unexpected income inclusions.COD creating large, unexpected income inclusions.Can create immediate cash tax liability if issuer does not have Can create immediate cash tax liability if issuer does not have enough NOLs to offset the COD incomeenough NOLs to offset the COD incomeEven issuers in serious financial trouble today have not necessarily Even issuers in serious financial trouble today have not necessarily built up sufficient NOLs to offset a sudden COD income inclusion built up sufficient NOLs to offset a sudden COD income inclusion from a debt modificationfrom a debt modification



30

American Recovery & Reinvestment Act of 2009 American Recovery & Reinvestment Act of 2009 (Stimulus Act)(Stimulus Act)

Election to defer recognition of COD, effective for transactions Election to defer recognition of COD, effective for transactions in 2009 and 2010 only. Does in 2009 and 2010 only. Does notnot apply to transactions apply to transactions occurring in 2011occurring in 2011

Recognize COD over 5-year period, beginning in 2014. Recognize COD over 5-year period, beginning in 2014. Must also defer corresponding OID deductions to match COD Must also defer corresponding OID deductions to match COD inclusions with OID deductionsinclusions with OID deductionsApplies to COD from debt reacquisitions. Applies to COD from debt reacquisitions.

By issuer or related personBy issuer or related personFor cash, new debt, or corporate stock or partnership interest if debt For cash, new debt, or corporate stock or partnership interest if debt contributed to capitalcontributed to capitalIncludes debt modificationsIncludes debt modificationsIncludes complete forgiveness of debt by holder.Includes complete forgiveness of debt by holder.

Available for -Available for -Debt issued by a C corporation (or other person if connected with a Debt issued by a C corporation (or other person if connected with a trade or business of that person)trade or business of that person)Debt issued in 2009 or 2010Debt issued in 2009 or 2010



31

American Recovery & Reinvestment Act of 2009 (Stimulus Act) American Recovery & Reinvestment Act of 2009 (Stimulus Act) (cont’d)(cont’d)

AHYDO rules suspended for - AHYDO rules suspended for - New debt issued in exchange for old debtNew debt issued in exchange for old debt

In debt-for-debt exchange (or modification)In debt-for-debt exchange (or modification)Old debt not an AHYDOOld debt not an AHYDOAfter August 31, 2008 or in 2009After August 31, 2008 or in 2009» Notice 2010-11 extended the AHYDO suspension for new debt Notice 2010-11 extended the AHYDO suspension for new debt

issued during 2010. No extension for 2011 so far.issued during 2010. No extension for 2011 so far.No change in obligor, no contingent portfolio interest, no debts issued to No change in obligor, no contingent portfolio interest, no debts issued to related personsrelated persons

Subsequent exchanges with same effective dates.Subsequent exchanges with same effective dates.Treasury granted authority to - Treasury granted authority to -

Extend suspension of AHYDO rules into the futureExtend suspension of AHYDO rules into the futureTemporarily substitute a higher rate for the AFR in the definition of AHYDO Temporarily substitute a higher rate for the AFR in the definition of AHYDO after 2009after 2009Both permitted if conditions in the debt capital markets continue to be Both permitted if conditions in the debt capital markets continue to be distresseddistressed



32

Open Questions on the Proposed Regulations Open Questions on the Proposed Regulations Defining “Publicly Traded”Defining “Publicly Traded”

The de minimis trading exception refers to “trades,” does this The de minimis trading exception refers to “trades,” does this mean that only actual trades are taken into account? In the mean that only actual trades are taken into account? In the context of a debt modification, is the deemed acquisition a context of a debt modification, is the deemed acquisition a “trade” for these purposes?“trade” for these purposes?The FMV of a debt instrument is presumed to be equal to its 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. If more than one traded price, sales price or quoted price is available, a taxpayer traded price, sales price or quoted price is available, a taxpayer may use any reasonable method, consistently applied, to may use any reasonable method, consistently applied, to determine the price determine the price

Is this presumption irrebutable for debt instruments for which only Is this presumption irrebutable for debt instruments for which only one price is available? one price is available? How does this rule compare with the special rule for property for How does this rule compare with the special rule for property for which there is only an indicative quote?which there is only an indicative quote?



33

SummarySummary

Debt modifications trigger COD and AHYDO rulesDebt modifications trigger COD and AHYDO rulesTax rules value debt according to market value where possibleTax rules value debt according to market value where possibleMarket values plummeted suddenly due to disruption in credit Market values plummeted suddenly due to disruption in credit marketsmarketsDebtors surprised by tax effectsDebtors surprised by tax effects

Temporary relief available for transactions occurring Temporary relief available for transactions occurring in 2009 or 2010in 2009 or 2010

Will this temporary relief be extended for 2011?Will this temporary relief be extended for 2011?Opportunity to craft permanent fixesOpportunity to craft permanent fixes



34

International Aspects of Financial Transactions

International Aspects of Financial Transactions

Broaden portfolio interest deductionBroaden portfolio interest deduction

Expansion of section 956Expansion of section 956

35

Expansion of portfolio interest exemption from withholding tax


Current limitations are substantial:Current limitations are substantial:

Must be unrelated parties (even a 10% shareholder Must be unrelated parties (even a 10% shareholder cannot receive interest free of U.S. withholding tax)cannot receive interest free of U.S. withholding tax)

Must not be “received by a bank on an extension of Must not be “received by a bank on an extension of credit made pursuant to a loan agreement entered into credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business”in the ordinary course of its trade or business”

Must not be subject to certain contingenciesMust not be subject to certain contingencies

36



Does the limitation to unrelated parties make sense Does the limitation to unrelated parties make sense (e.g., why not let a non-U.S. person hold convertible (e.g., why not let a non-U.S. person hold convertible debt)?debt)?

Even if it generally makes sense, should it be relaxed Even if it generally makes sense, should it be relaxed (e.g., to more than 50% share ownership)?(e.g., to more than 50% share ownership)?

37



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

38



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

39

Expansion of portfolio interest exemption from withholding taxExpansion of portfolio interest exemption from withholding tax

What about a portfolio dividend provision (at least for What about a portfolio dividend provision (at least for dividends paid on certain types of equity)?dividends paid on certain types of equity)?

Only preferred stock? Only preferred stock? Also common stock?Also common stock?

Should a portfolio dividend provision replace the Should a portfolio dividend provision replace the portfolio interest exemption? portfolio interest exemption?

40

Pledge of CFC Stock

Loan Exceeds FMV of CFC

Stock Pledge

U.S. Borrower

U.S. BorrowerLenderLender

““Deemed Dividend” of $1000

U.S. Borrower

U.S. Borrower

CFC

(E&P = $1000)

CFC

(E&P = $1000)

CFC

(E&P = $1000)

CFC

(E&P = $1000)

“Deemed Dividend” of $1000

GUARANTEE GUARANTEE

LenderLender$1000

Multiple Inclusions Exceed Borrowing

Guarantee

FMV = $500E&P = $1000

U.S. BorrowerU.S. Borrower

CFCCFC

AssetsAssets

LenderLender

CFC

(E&P = $1000)

CFC

(E&P = $1000)

$1000


$1000

Pledgeof

$100 Asset

FMV = $2000

U.S. BorrowerU.S. Borrower

CFC

(E&P = $1000)

CFC

(E&P = $1000)

AssetsAssets

LenderLender $1000

AssetsAssets

FMV = $100

Loan Exceeds FMV of Pledged Asset



41

DerivativesDerivatives

Major issuesMajor issuesCredit derivativesCredit derivativesDodd-Frank Dodd-Frank

Secondary issuesSecondary issues

42

Derivatives Derivatives

Credit Default SwapsCredit Default SwapsTRS and other credit derivatives all converged in TRS and other credit derivatives all converged in CDSCDSNeed for regulating CDSNeed for regulating CDS

Self regulation – big bangSelf regulation – big bangFederal govt. regulation – Dodd-FrankFederal govt. regulation – Dodd-Frank

Tax treatment Tax treatment Never settled prior to Dodd-Frank, several approachesNever settled prior to Dodd-Frank, several approachesPost Dodd-Frank with clearinghouses and standardizationPost Dodd-Frank with clearinghouses and standardization

43


CDS Clearinghouse OperationsCDS Clearinghouse Operations

Clearinghouse Corporation/Intercontinental Exchange Clearinghouse Corporation/Intercontinental Exchange ClearinghouseClearinghouse

Regulated by New York banking department and Federal Regulated by New York banking department and Federal ReserveReserve

Trades negotiated OTC, then submitted to clearinghouseTrades negotiated OTC, then submitted to clearinghouse

Clearinghouse becomes sole counterparty; daily netting occurs.Clearinghouse becomes sole counterparty; daily netting occurs.

Index contracts only initiallyIndex contracts only initially

Participants currently limited to banks and broker-dealers.Participants currently limited to banks and broker-dealers.

Chicago Mercantile Exchange/Citadel Exchange and Chicago Mercantile Exchange/Citadel Exchange and ClearinghouseClearinghouse

Trades entered into on exchangeTrades entered into on exchange

Otherwise expected to function similarlyOtherwise expected to function similarly

European ClearinghouseEuropean ClearinghouseLiffe/LCH-Clearnet Clearinghouse (launched December 2008).Liffe/LCH-Clearnet Clearinghouse (launched December 2008).

NYSE Euronext/Eurex ClearinghouseNYSE Euronext/Eurex Clearinghouse

44


Tax IssuesTax Issues

Clearinghouse is not an exchangeClearinghouse is not an exchangeEffect on insurance/guarantee vs. derivative issueEffect on insurance/guarantee vs. derivative issueEffect on pending timing rules?Effect on pending timing rules?

Is clearinghouse an exchange for purposes of Is clearinghouse an exchange for purposes of section 1256?section 1256?

Possible mismatch in character and timing with hedges (mixed Possible mismatch in character and timing with hedges (mixed straddles)straddles)Competitive (dis)advantage vs. non-exchange CDSs?Competitive (dis)advantage vs. non-exchange CDSs?What happens if CDS is cleared in mid-life?What happens if CDS is cleared in mid-life?

Last page of Dodd-Frank and effect on swaps not Last page of Dodd-Frank and effect on swaps not mentioned therementioned there

45

DerivativesDerivatives

Secondary issuesSecondary issuesMark to market for a broader class of instrumentsMark to market for a broader class of instrumentsAccrual of income on prepaid forwardsAccrual of income on prepaid forwardsNonrecognition of gain or loss on securities loansNonrecognition of gain or loss on securities loans

Documents

Andrew Needham Matthew Stevens Michael Novey Viva Hammer January 26, 2011