IRS Leaves Potential REIT Conversions Hanging

Recent federal securities law filings by two companies – one in the document management and storage business,4 the other an operator of data centers5 – suggest that the IRS has temporarily suspended REIT conversion rulings while it analyzes the meaning and scope of “real estate” under tax rules governing REITs.

According to one of the filings, the “IRS has convened an internal working group to study what constitutes ‘real estate’ for purposes of the REIT provisions” and, “pending the completion of the study, the IRS is unlikely to issue PLRs on what constitutes real estate for REIT purposes.”6

The IRS’ moratorium on REIT conversion rulings may come as a surprise to some.  Indeed, as a historical matter, the IRS has issued a litany of positive rulings sanctioning numerous non-traditional real estate assets. This expanding definition of a real estate asset beyond the traditional “brick and mortar” concept, and a desire to take advantage of the generous tax rules governing REITs, seem to have whet the market’s appetite for REIT conversions.

The IRS hasn’t been an unwilling participant. In fact, just this year alone, the IRS has issued three REIT conversion rulings, blessing private correctional facilities as well as a data center.7 A number of other proposed REIT conversions have been rumored to be in the works, such as businesses involving outdoor advertising, hospitality, cellular towers and solar power generation. The IRS’ moratorium, however, may throw a kink in the growing REIT conversion trend. Also, since there has not been a formal announcement of the IRS position, its scope is unclear.

IRS proposes to relax wash sale rules for floating nav money market fund share redemptions

In Tax Talk 5.4 we reported on Securities and Exchange Commission (“SEC”) proposals to require certain money market funds to use a floating net asset value for share purchases and redemptions.8 In Notice 2013-48,9 the IRS announced a proposed revenue procedure to limit the scope of the wash sale rules under Section 1091 with respect to certain redemptions of money market fund shares. This guidance comes on the heels of proposed regulations issued in June by the SEC that would alter the rules that govern the prices at which certain money market fund shares are issued and redeemed, such that some funds would no longer retain a stable (typically $1.00) share price. The constant share prices had simplified the tax consequences of transactions involving money market fund shares because a shareholder does not realize gain or loss when a share is redeemed for an amount equal to its basis.

Where the price of shares in the money market fund are permitted to float, redemptions of shares may run afoul of the wash sale rules, which generally disallow a loss realized by a taxpayer on a sale or disposition of shares if, within a period beginning 30 days before and ending 30 days after the date of the sale or disposition, the shareholder acquires substantially identical shares.

Notice 2013-48, however, which addresses redemptions of shares in money market funds with a floating share price, contains a proposed revenue procedure that would give some relief for taxpayers if the SEC proposals are adopted. The proposed revenue procedure provides that where a redemption results in a de minimis loss, the IRS will not treat the redemption as part of a wash sale. For purposes of the proposal, a de minimis loss means a loss realized on a redemption of a share in a money market fund where the loss is not more than 0.50% of the taxpayer’s basis in that share. As a result, under Notice 2013-48, losses derived from redemptions of shares, where the redemption price is slightly (50 basis points) less than the taxpayer’s basis, will not be disallowed. Of course, the proposed revenue procedure also shows what happens if the de minimis rule does not apply and it’s not pretty.

IRS confirms Mexican Land Trust is not trust under U.S. tax law

In Revenue Ruling 2013-14, the IRS ruled that a Mexican Land Trust (“MLT”) did not constitute a trust under U.S. tax law. This recently released public guidance confirms a prior private ruling,10 providing comfort to taxpayers at large that an MLT would not require them to comply with various (and potentially onerous) U.S. tax rules governing foreign trusts.

By way of background, the Mexican Federal Constitution prohibits non-Mexican persons from directly holding title to residential real property in certain areas of Mexico (“restricted zones”). Non- Mexican persons, however, may hold residential real property located in the restricted zones through an MLT with a Mexican bank after obtaining a permit from the Mexican Ministry of Foreign Affairs.

The ruling describes three factual scenarios of ownership of property located in a designated restricted zone.

In the first scenario, the property is held by the MLT through an arrangement with an LLC organized under state law, which the taxpayer has opted to treat as a disregarded entity. The second situation is the same as the first, but the MLT holds legal title on behalf of a U.S. corporation. Finally, in the third iteration, the taxpayer deals directly with the MLT in its capacity as an individual; no entity is interposed.

Under each scenario, the IRS ruled that the MLT did not constitute a trust under U.S. tax law, which generally defines a trust as an arrangement created by a will or by an inter vivos declaration under which a trustee takes title to property for the purpose of protecting or conserving it for the beneficiaries,11 because the MLT merely held legal title to the property.

Indeed, central to the IRS’ ruling was the fact that the MLT held only legal title to the real property. Upon sale of the property, the MLT was simply required to transfer title, nothing more. On the other hand, the MLT agreement provided that the taxpayer retained exclusive control of the management, operation, renting and selling of the real property, together with an exclusive right to the earnings and proceeds from the real property. The MLT further required the taxpayer to file all tax returns, pay all taxes and satisfy any other liabilities with respect to the real property. Finally, the MLT disclaimed all responsibility for the real property, and it was not required to maintain or defend it.

In short, because the taxpayer retained management and control of the real property, the trustee of the MLT (i.e., the Mexican bank) was a mere agent for the holding and transfer of title to the real property, and the taxpayer retained direct ownership of the real property for U.S. federal income tax purposes.

Third Circuit: S Corp flow-through tax treatment not property of debtor under the Bankruptcy Code

On May 21, 2013, the Court of Appeals for the Third Circuit held that a bankrupt entity’s flow-through tax status as a qualified subsidiary of an “S corporation” was not its property and, therefore, was not entitled to bankruptcy court protection.

In The Majestic Star Casino LLC v. Barden Development, Inc., an individual held a 100% interest in Barden Development, Inc. (“BDI”), an Indiana corporation that elected to be treated as an S corporation. In general a corporation that files an “S election” is eligible for passthrough treatment and is not subject to tax at the corporate level. An S corporation can also elect to treat a qualifying 100%-owned subsidiary as a qualified subchapter S subsidiary (a “QSub”), with the result that the subsidiary is disregarded for federal income tax purposes. In this case, BDI indirectly held a 100% interest in Majestic Star Casino II (“MSC II”), a Delaware corporation, and elected to treated MSC II as a QSub. On November 23, 2009, MSC II and other BDI subsidiaries filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. BDI, however, did not file for bankruptcy, and at the petition date, BDI remained an S corporation and MSC II remained a QSub.

Following the petition date, BDI filed a notice with the IRS to revoke its status as an S corporation, which had the collateral effect of terminating MSC II’s status as a QSub. According to MSC II, this revocation resulted in a $2.26 million tax bill in the state of Indiana. MSC II subsequently filed an adversary complaint against both BDI and the Internal Revenue Service (“IRS”) to restore BDI’s status as an S corporation and MSC II’s status as a QSub on the theory that the QSub status of MSC II was property of the debtor’s estate and, therefore, its transfer was a violation of the automatic stay. The IRS and BDI responded that MSC II’s QSub status was not property, that even if it were property, it was not property of MSC II, and that no “transfer” of property occurred when BDI terminated its S election and triggered the loss of MSC II’s QSub status.

The bankruptcy court held that MSC II’s status as a QSub was property of MSC II and revocation of BDI’s S corporation status was void and of no effect.12 The court ordered BDI and the IRS to take all actions necessary to restore the status of MSC II as a QSub.

The Third Circuit overturned the bankruptcy court on two theories. First, the Third Circuit called into question the decisions of other courts concluding that an election to be treated as an S corporation is property of the debtor.13 These decisions, the court noted, were based on case law holding that net operating losses (“NOL”) of the debtor are part of the debtor’s estate. The Third Circuit found the extension of the NOL precedents to the S election untenable and distinguished the two based on the fact that the tax status of an entity is contingent in a way that NOLs are not, and that the value of an S election is dependent upon it not being revoked by its shareholders. Ultimately, the court found that “capacious as the definition of ‘property’ may be in the bankruptcy context, we are convinced that it does not extend so far as to override rights statutorily granted to shareholders to control the tax status of the entity they own.” Finding that status as an S corporation is not “property” for purposes of the Bankruptcy Code, the court concluded that arguing that QSub status is “property” is an even weaker claim.

Second, the court held that, even if QSub status were “property,” the property would belong to the S corporation parent, not the QSub debtor because “the corporation retains no real benefit from its tax-free status in that, while there is no entity-level tax, all of its pre-tax income is passed on to its shareholders.” The court also noted that “because the desirability of a Subchapter S election depends on the individual tax considerations of each shareholder, the final determination of whether there is to be an election should be made by those who would suffer the tax consequences of it.”

Accordingly, the Third Circuit vacated the bankruptcy court’s decision.

Treasury signs FATCA IGAs with Spain, Germany and Japan

In Q2, the U.S. Treasury has again been busy making good on its promise to conclude intergovernmental agreements (“IGAs”). These IGAs represent an intergovernmental approach to implementing FATCA.

In May, the U.S. Treasury signed so-called “Model I” agreements with Spain and Germany. Model I IGAs generally permit a financial institution in the FATCA partner country to provide information on U.S. account holders to its own government, which, in turn, will pass that information to the IRS. In this way, German and Spanish financial institutions will generally not be required to enter into agreements – referred to as an “FFI Agreement” in FATCA parlance with the IRS (although they will still be required to register their FATCA status with the IRS via an online registration portal, which is supposed to be accessible August 19, 2013).

Moreover, in June, the U.S. Treasury signed a “Model II” agreement with Japan. In contrast to a Model I IGA, the “Model II” IGA between the U.S. and Japan, styled as a “Statement of Mutual Cooperating and Understanding,” requires Japanese financial institutions to enter into FFI Agreements with the IRS. The FFI Agreements will generally require Japanese financial institutions to conduct due diligence and report information related to their U.S. accounts directly to the IRS, in order to avoid withholding.

Finally, the U.S. and Switzerland signed a Memorandum of Understanding (“MOU”) supplementing the FATCA agreement they signed in February. The MOU generally summarizes the obligations of Swiss financial institutions, states the relationship with the qualified intermediary system and confirms the simplified self- declaration for exempt Swiss beneficial owners under the FATCA agreement.

For copies of the agreements with Japan, Germany, Spain and Switzerland; updated withholding forms (Forms W-8); and a wealth of other FATCA-related resources, see our FATCA website, KNOWFatca (

Structured finance transaction treated as “Conversion Transaction,” taxed as straddle

It should be no surprise that many U.S. taxpayers are looking high and low for “capital gain generators” to offset capital losses suffered during the Financial Crisis. In fact, for taxpayers that recognized their capital losses in 2008, time is running out: corporate taxpayers can only carry over capital losses for five years under Section 1212. A recent IRS Field Attorney Advice (“FAA”) shows how one taxpayer tried to address its expiring capital loss problem. From Tax Talk’s perspective, the FAA is important because it focuses on tax deductions for payments made pursuant to credit-linked notes (“CLNs”) and whether prepaid forward contracts can be recast as “conversion transactions” under Section 1258, resulting in capital gains being recharacterized as ordinary income.

To greatly simplify the facts, the taxpayer (“Parent”) and a bank (“Bank”) formed a special purpose vehicle (“SPV”) that was a U.S. corporation for federal income tax purposes. The Parent owned 80% of the SPV’s common stock, which would permit it to include the SPV in its consolidated tax group. The Bank owned the remaining 20% of the SPV’s common stock and 100% of its preferred stock. The Bank’s ownership of the preferred stock entitled it to consolidate the SPV for financial accounting purposes. The Bank also had a call option to purchase the Parent’s 80% stake.

The SPV loaned its capital to one of the Parent’s domestic subsidiaries. The loans were in the form of CLNs, each with a 5-year maturity and a floating interest rate. The terms of the CLNs permitted the subsidiary to repay the notes with cash or a specified portfolio of debt instruments (“Reference Portfolio”). On its tax return, the subsidiary deducted the interest payments on the CLNs. The SPV would include the income from the CLNs so that the CLNs’ deductions and income were a “wash” under the consolidated return regulations.

The domestic subsidiary took the CLNs’ proceeds and entered into prepaid forward contracts with one of the Parent’s foreign subsidiaries. At maturity, which coincided with the 5-year term on the CLNs, the domestic subsidiary was entitled to receive a basket of investment-grade debt securities – assets that largely overlapped the Reference Portfolio. The domestic subsidiary did not include income currently on the prepaid forward contracts, relying on the general tax treatment of forward contracts as open transactions. And, when the domestic subsidiary terminated the prepaid forward contracts, it reported a capital gain.

The point of the structure was to generate a capital gain in the domestic subsidiary through termination of the prepaid forward contracts, which would be offset by the Parent consolidated group’s expiring capital losses. The SPV would earn a return on the CLNs that would wind up as cash (or the reference debt instruments) when the CLNs were retired. Then, the Bank could buy the Parent’s common stock in SPV pursuant to the option. At that point, the Bank could leave SPV in place forever or liquidate it under Section 332.

The IRS concluded that the long forward contract and the embedded short position in the CLNs was a Section 1092 straddle. (Presumably, the underlying reference assets were actively traded.) Thus, the IRS reasoned if the domestic subsidiary received the Reference Portfolio pursuant to the forward contract, it could use the Reference Portfolio to pay off the CLNs. If the forward contract lost value (i.e., the reference assets diminished in value), the domestic subsidiary was protected in that it could take delivery of the assets to pay off the CLNs. As to the interest rate swap with the parent, the IRS reasoned that the domestic subsidiary was protected from rising interest rates (which would cause the floating rate on the CLNs to rise and the forward’s reference property to lose relative value). As a result, the domestic subsidiary’s risk of loss in the underlying portfolio assets was substantially diminished. Based on these conclusions, the IRS disallowed any deduction for payments on the CLNs and interest rate swaps under Section 263(g).

The FAA next concludes that the forward contract plus CLNs represented a Section 1258 “conversion transaction” as to domestic subsidiary. It reasons that gain on the forward would be offset by a loss on repayment of the CLN, leaving the domestic subsidiary net a time value of money return.

Under the terms of the forward contracts, the domestic subsidiary was entitled to receive interest on the underlying portfolio of assets, as well as the portfolio of assets itself on settlement. Likewise, the SPV was entitled, interest payments and, if the domestic subsidiary chose, delivery of a basket of investment- grade assets. In both cases, the IRS pointed out, the long party was entitled to receive an annual return based on the time value of money and the right to receive a portfolio of securities five years in the future that was equal in value to the amount of money initially transferred at the opening of the transaction. As a result, the prepaid forward contracts were recharacterized as conversion transactions, and the capital gain recognized converted to ordinary income.

If the IRS’ position were ultimately upheld, the net effect of the FAA seems to be that the taxpayer’s capital losses would expire, and the consolidated group would recognize ordinary income from the prepaid forward and interest income on the CLNs. Of course, the FAA cannot be used or cited as precedent and only represents the government’s opinion, which the taxpayer is free to dispute.

IRS limits taxpayer’s holding period, denies DRD

U.S. corporate taxpayers from time to time enter into stock programs where they acquire a basket of dividend paying stocks and then attempt to enter into a “portfolio hedge” with respect to the basket. The trick is to obey the rules in Regs. Section 1.246-5 that tell taxpayers when the hedge will be treated as an offsetting position that kills the taxpayer’s holding period (and eliminates its ability to claim the 70% dividends-received deduction). In recent private guidance,14 the IRS addressed one aspect of what appears to be such a program.

The taxpayer (“X”) and its four consolidated subsidiaries held portfolios of equity securities that paid dividends to X and its subsidiaries. To protect against a downturn in the equity markets, X wrote and purchased cash-settled put and call options on the S&P 500 Index. These positions limited the gains on the equity portfolio but also protected X and its subsidiaries from loss.

Generally, a corporation is entitled to a dividends- received deduction (“DRD”) with respect to dividends it receives from domestic corporations subject to income tax. However, no deduction is available if the stock is held for 45 days or less in the 91-day period beginning on the day that is 45 days before the date on which the shares become ex-dividend. Any period during which the risk of loss on the stock is diminished by “holding one or more other positions with respect to substantially similar or related property” does not count toward the holding period requirement. Furthermore, Treasury regulations provide that positions held by parties related to the taxpayers are considered held by the taxpayer “if the positions are held with a view to avoiding the application of [the holding period requirement].” At issue was whether X’s position in the S&P options could be treated as held by its subsidiaries, reducing the holding period of the subsidiaries in its equity portfolio and therefore disqualifying the subsidiaries from taking a DRD with respect to the dividends. (Unfortunately, X had already conceded that the S&P options constituted an offsetting position with regard to “substantially similar or related property.”15

X sought to demonstrate that the S&P option positions were not held “with a view to avoiding” the holding period requirement by presenting evidence that tax considerations were not considered in the establishment of the option program. Furthermore, in redacted text, X presented business reasons for the program.

The IRS, however, found that, notwithstanding any business reasons for entering into the hedging strategy, X knew about the offsetting positions and entered into the hedges in order to diminish the risk of loss on the equity portfolios held by it and its subsidiaries. The IRS concluded that this was sufficient to demonstrate that the positions were held with a view to avoiding the application of the holding period requirement.

IRS disallows DRD on substance over form grounds

CCA 201320014 exposes an oft-forgotten (even by Tax Talk) tax rule: section 245. That section provides that a U.S. corporation is entitled to a dividends-received deduction for dividends received from a foreign corporation in certain circumstances. For the special rule to apply, (i) the U.S. corporation must own at least 10 percent of the foreign corporation’s stock by vote or value, and (ii) only the U.S. source portion of the dividend qualifies for the DRD. The U.S. source portion is the percentage of the foreign corporation’s earnings either (i) effectively connected with a U.S. trade or business or (ii) consisting of dividends received from a U.S. corporation 80% owned by the foreign corporation. It seems the taxpayer in CCA 201320014 tried to exploit this latter provision by using a “flow through” U.S. corporation whose dividends were not subject to U.S. withtholding tax.

The taxpayer in the CCA was the common parent of a consolidated group. As part of its business, the taxpayer’s operating subsidiary received significant amounts of cash collateral from its customers. Prior to the transactions at issue, the subsidiary would routinely invest the collateral in high-grade liquid assets and would retain the difference between the amounts earned on the investments and the amounts payable to customers.

According to the CCA, the taxpayer decided that it could earn a better after-tax return on these investments if it routed the money through a series of entities, the increase in yield equaling the amount of U.S. tax savings. What it did was invest the money in a controlled foreign corporation (“CFC”) that in turn invested the money in stock of a U.S. regulated investment company (“RIC”). The CFC owned at least 80% of the RIC’s stock. To avoid current inclusion of the income under subpart F, the taxpayer sold the CFC’s stock before the end of the taxable year. Gain on the sale was treated as a dividend under section 1248.

This structure, if respected, would reduce the tax liability on the interest attributable to the high-grade securities by 80 percent, the amount of the DRD generated by the distribution, without giving rise to any additional tax. Importantly the RIC’s dividends to the foreign subsidiary would be free of withholding tax. Generally, a dividend by a U.S. corporation to a foreign shareholder is subject to a 30 percent withholding tax. However, there is an exception to this withholding tax for interest-related dividends paid by RICs to foreign shareholders. This exception exists because interest earned by foreign shareholders is generally free from U.S. withholding tax, and the Code seeks to put foreign shareholders in a RIC that invests in debt in the same position as if the foreign shareholders had invested in the debt directly.

The CCA concludes that the taxpayer was not entitled to the DRD on substance over form grounds, arguing that the transaction lacked a valid business purpose. Notably, the IRS did not argue in the CCA that the transaction was outside the literal meaning of the Code. Instead, the IRS determined that the transaction circumvented the intent of the CFC, DRD and RIC rules and found that the transaction lacked a valid business purpose: “Although investing the Customer Funds served a business purpose, routing the investment and investment returns through [the foreign subsidiary] and RIC did not serve a meaningful business purpose. Rather, the indirect investment strategy was a contrivance to avoid U.S. federal income tax.”

Acquisition of medium term notes by foreign bank’s U.S. branch eligible for "10% Rule”

A recent IRS technical advice memorandum (“TAM”) addressed the source of interest from medium term notes (“MTNs”), which were acquired by the U.S. branch of a foreign bank solely to be posted as collateral to access the Federal Reserve Bank Discount Window and secure funding for its U.S. banking business.16

In the TAM, a foreign bank, through its domestic branch, engaged in a banking business in the United States. As part of its business, the branch made loans to the public, which the foreign bank held for its own accounts and not for sale. The branch also solicited and negotiated various liquidity and credit-support commitments with U.S. counterparties. To maintain these commitments, the foreign bank was required to provide liquidity and credit support to the counterparties. The outstanding commitments, however, exposed the foreign bank to significant liquidity risk. To manage these risks, the foreign bank’s domestic branch was required to maintain access to the Federal Reserve Bank Discount Window. It did so by posting collateral in the form of MTNs acquired from various commercial banks on the interbank market.

The key question the IRS analyzed was whether the entire amount of interest derived from the MTNs was effectively connected with the conduct of a U.S. banking business, or whether the interest income could be allocated between effectively connected and non- effectively connected income under the so-called “10% rule.”17 Under U.S. tax law, income earned in connection with a U.S. trade or business is generally subject to U.S. taxation. On other hand, income that is not effectively connected with a U.S. trade or business is subject to 30% withholding, which is usually substantially reduced, either by treaty or, in this case, possibly the exemption from withholding for portfolio interest.

As a threshold matter, the IRS determined that the foreign bank, through its domestic branch, had engaged in a banking business in the U.S. However, to determine whether the income earned on the MTNs was effectively connected with this business, the IRS had to first assess whether the MTNs were acquired, (1) as a result of, or in the course of making loans to the public; (2) in the course of distributing them to the public; and (3) for the purpose of satisfying the reserve requirements established by the U.S. banking authorities. If the answer to each of these questions was no (i.e., the MTNs did not fall into any of the three categories), then the interest income would be allocated under the residual 10% rule. As such, only a portion of the interest would be effectively connected income and subject to U.S. taxation.

The IRS ultimately concluded that the income could be allocated under the 10% rule. In reaching this conclusion, the IRS found that the MTNs had been purchased solely as collateral, not in the course of making loans to the public. The IRS also concluded that the MTNs were not purchased for the purpose of distribution to the public, as the foreign bank did not act as an underwriter or market maker with respect to the MTNs and, after purchasing them, did not distribute them. Finally, the IRS ruled that the MTNs could not satisfy the reserve requirements under applicable banking regulations and, as a result, the MTNs were not acquired for the purpose of meeting such reserve requirements. Thus, the MTNs fell into the residual category and any interest could be allocated under the 10% rule.

U.S. District Court finds tax opinion condition could not have been met in MBIA v. Patriarch Partners

Many contracts require tax opinions as a precondition for a party to take an action or refrain from taking an action. On June 10, 2013, the U.S. District Court for the Southern District of New York decided MBIA v. Patriarch Partners18 in part on whether a debt-equity tax opinion could have been rendered. The case involved a complicated securitization transaction where Patriarch (an investment manager) agreed to manage a series of collateralized debt obligation (“CDO”) trusts whose bonds were insured by bond insurer MBIA. In exchange, Patriarch agreed to contribute subordinated notes (the so-called Class B Notes) from a new Patriarch-sponsored CDO to one or more of the CDO trusts but only if certain conditions were met. The conditions included that the Class B Notes be rated at least investment grade and that they “shall” be treated as debt for federal income tax purposes. The district Court found, in a 151-page opinion after a two week trial involving 13 witnesses, that neither condition was met.