The following will be one relatively large post that will cover some of the more notable developments since my last blog which unfortunately was quite awhile ago. It has been a bit more difficult for me to post as of late due to a large number of transactions closing towards yearend and some personal matters. I will try to cover things in chronological order.
Section 892 Proposed Regulations Clarify Some Sovereign Fund Issues
Sovereign funds are significant and active participants in investment funds not only in the United States but in many other countries. Most jurisdictions have some pro-taxpayer law that exempts sovereign funds from taxation in the source country jurisdiction. Naturally, this law is designed to increase foreign investment by such funds. The U.S. has enacted Section 892 of the Code which generally provides that the income of foreign governments received from investments in the United States in investment securities, financial instruments, or interest on deposits in banks in the United States of moneys belonging to such foreign governments is exempt from income tax (i.e. the exemption is only under Subtitle A of the Code). The term “foreign government” includes only the integral parts or controlled entities of a foreign sovereign. In turn, the term “controlled entity” encompasses an entity that is separated in form from a foreign sovereign if it satisfies the following requirements: (i) It is wholly owned and controlled by a foreign sovereign directly or indirectly through one or more controlled entities; (ii) It is organized under the laws of the foreign sovereign by which owned; (iii) Its net earnings are credited to its own account or to other accounts of the foreign sovereign, with no portion of its income inuring to the benefit of any private person; and (iv) Its assets vest in the foreign sovereign upon dissolution.
Foreign sovereign funds often qualify as “controlled entities” and are thus exempted under Section 892. However, there has been an issue with investments by sovereign funds in partnerships. The exception does not apply to entities that are “controlled commercial entities” which generally means any entity engaged in commercial activities that is controlled by the foreign government. Moreover, under the current temporary regulations, the commercial activities of a partnership are attributable to the partnership’s general and LIMITED partners. This created uncertainty for sovereign funds that invest in partnerships because it exposed the fund to a possible taint of all of its activities unless the fund invested in each project through a blocker. Newly proposed Reg. § 1.892-5 (REG-146537-06, 11/03/2011), however, alleviates this issue by providing for a limited partner exception. Under this new exception, an entity that is not otherwise engaged in commercial activities will not be treated as engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership. For this purpose, an interest as a limited partner in a limited partnership is defined as an interest in an entity classified as a partnership for federal tax purposes if the holder of the interest does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year under the law of the jurisdiction in which the partnership is organized or under the governing agreement. Notably, despite of the exception, the controlled entity partner’s distributive share of partnership income attributable to the partnership commercial activity will be considered to be derived from the conduct of commercial activity, and therefore will not be exempt from taxation under section 892. Nonetheless, to some foreign sovereigns the blocker issue may be significantly minimized after the regulations. Others sovereigns, however, may still push funds to invest through blockers or set up blocker feeders, or alternatively continue to set up their own dedicated blocker feeders, if the sovereign is not willing to bear the cost and deal with filing a U.S. tax return for any income derived from the U.S. partnership. At least to me and a few other colleagues that I’ve talked to, this is a welcome change that could hopefully lead to at least marginal tick up in sovereign investments in the U.S.
Samueli v. Comm’r: securities lending gone sour
This case, won unilaterally by the Commissioner, merits only a brief mentioning because it involves a promoter transaction whereby the taxpayer’s sole motivation for the transaction was tax avoidance. As a general rule, most funds would engage in transactions that are motivated by business purposes. Nonetheless, the case analyzes the relatively unsettled topics of securities lending, which involves tax ownership authorities that are also applicable in monetization strategies such as VPFs, repos and so on, and thus, it is worth reading. Also, the case is interesting because, similarly to the Anschutz case below, it involves kind of a celebrity billionaire taxpayer, the Samueli family who are basically the co-founders of Broadcom Corporation. In Samueli v. Comm’r., 108 AFTR 2d 2011-6270 (CA9, 11/1/2011), the taxpayer, under the tutelage of now long-failed Arthur Andersen LLP, engaged in a securities lending transaction produced by Twenty- First Securities. In its economic essence, the transaction consisted of purchasing a security with a fixed rate of return determined by interest rates at the time of purchase, and paying for that purchase at a price derived from a variable interest rate. However, the transaction as executed was considerably more complex and involved multiple steps, including the purchase and lending of securities.
The principle issue as with many monetization transactions was whether the transaction constituted an actual loan or a sale (in this instance a securities loan under Section 1058). Section 1058 has an express requirement that a transaction should “not reduce the … opportunity for gain of the transferor of the securities in the securities transferred.” It seems that the taxpayer in this case committed the cardinal mistake of having a limited call right that enabled it to terminate the loan only on one of three dates, which in turn limited the taxpayer’s ability to profit from any short-term increase in the value of the securities. In the above regard, the case involves an interesting issue of statutory construction. As obvious from the above quote, the opportunity of gain must no be reduced, but the statute does not provide for how long. The taxpayer retained such an opportunity but only at specified times, contrary for example to the case if the taxpayer would have provided for a on demand termination of the securities loan, in which case the opportunity for gain would have spanned across the entire time span of the lending. The taxpayer had, what I thought, a very clever argument basically saying that Section 512(a)(5)(B) (which imposes requirements in addition to Section 1058) has an on demand termination requirement, which in essence would render a similar on demand requirement under Section 1058 superfluous. As it clever it might have been, this argument did not work for the taxpayer. One would naturally wonder whether this whole pickle for the taxpayer could have been avoided if the documents have simply contained an on demand provision, which in light of the “opportunity for gain” requirement might have been prudent.
Rodriguez v. Comm’r: the Tax Court sides with Notice 2004-70 in a recent qualified dividend decision
U.S. investors in foreign funds sometimes participate in entities that are treated as corporations for U.S. tax purposes. This is not the norm, but in some instances, the fund may be a PFIC (e.g. either because it is intentionally structured this way, or because the U.S. investors are a minority and the sponsor does not care about going through the administrative burden of making a check the box election and providing substituted K-1s). As the case may be, if the fund is in certain treaty jurisdictions, a question comes up whether any actual or deemed distributions could be qualified dividends under the Code (i.e. taxed for now at 15%). Quite unfortunately, this issue is not straight forward and more complicated than it needs to be. This particular case, Rodriguez v. Comm’r., 137 T.C. No. 14 (12/7/11), addresses the limited issue of whether Subpart F inclusions are qualified dividends. The issue has not been very controversial, at least in the tax community, after the issuance of Notice 2004-70 which basically concluded that since nothing in the Code provides that Subpart F inclusions are to be treated as dividends for Section 1(h) purposes, they cannot be qualified dividends. While this somewhat makes sense on a logical and technical level, taxpayers did not really have a case until know that delved into the issue in earnest. This case does this. The most persuasive reasoning of the Court, at least in my opinion, was that according to its legislative history, section 1(h)(11) was intended in part to remove a perceived disincentive for corporations to pay out earnings as dividends instead of retaining and reinvesting them. Thus, at least according to the Court, it makes sense that a “deemed” distribution (i.e. something that is not actually paid out but retained offshore) does not fit within this intent. This also would explain the difference between actually distributed previously untaxed dividends (which are qualified dividends) as compared to Subpart F inclusions. After all, the purpose of the qualified dividend is to stimulate distributions by offering a lower rate on the distributed income, and with deemed dividends, no such stimulus occurs because the earnings are subject to tax irrespective of whether they are distributed. Whether this logic makes sense will possibly be tested on appeal. We will monitor any appeal filings and report here.
New Temporary Foreign Asset Reporting Regulations
Here we have another reporting obligation that has often been mentioned on the blog. The recent FATCA Section 6038D requires that U.S. persons report foreign financial assets. I have expressed my frustration on this blog about the multitude of requirements that could befuddle, befall, and hang like a Damocles’ sword over the head of an unsuspecting taxpayer. These requirements are not often well coordinated, are duplicative and frankly are overly-burdensome to many. This particular requirement, which is manifested in filing Form 8938 could apply to investors in foreign private equity, venture capital and hedge funds, regardless of the fact that such investors may not be subject to an FBAR filing requirement. In an attempt to reduce this burden, the newly issued proposed and temporary regulations under Section 6038D (T.D. 9567 – effective on December 19, 2011) provide specific duplicative reporting relief. Pursuant to this relief a taxpayer that is otherwise required to file Form 8938 would not have to report the foreign assets if the asset is reported or reflected on a Form 5471, Form 8621, Form 8865, or Form 8891. This list of forms encompasses forms that are often applicable to investors in foreign funds. Thus, the IRS has made clear that, assuming the investor is timely filing one of these forms (such as the now mandatory Form 8621), it should be able to dispense with the reporting on Form 8938. Notably, however, this does not mean that Form 8938 does not have to be filed. Some practitioners, and I am sure many laymen, would be surprised by this, and confused by the logic and purpose of the rule. The temporary regulations provide that for a specified foreign financial asset excepted from reporting on Form 8938, the taxpayer must report the number of each type of form on which the asset is reported directly. I suppose the IRS has decided that filing one form is not sufficient, and thus, another form is required to tell the IRS that the first form was filed. In a conclusive random musing, I hope that there are other reasons that I am not seeing here that could validate and explain this requirement.
Anschutz is finally affirmed
Finally, to end this post, on December 27th, Anschutz was decided in favor of the Government in the 10th Circuit (10 CIR No 11-9001). I am not going to cover this in detail since the decision has been mentioned on this blog several times in the context of VPFs and monetization strategies. The Tax Court decision below was one of a series of decisions that for various reasons rejected monetization strategies implemented by the taxpayer. While this case seems to have reached closure (one may guess that further appeal would be futile), others are still on appeal and I will try to cover any future developments.