Friday, April 01, 2011

Securities Industry Asks IRS for Comfort in Complying with Derivatives Provisions of Dodd-Frank

In a letter to the IRS, the securities industry has asked for official confirmation that the assumption of a derivative position by a related derivatives dealer does not cause the assignor’s counterparty to be deemed, for tax purposes, to have terminated its position and entered into a new one. IRS guidance in the form of a notice or other official pronouncement is needed on this point to allow derivatives dealers to properly implement key provisions of Dodd-Frank. SIFMA fears that a failure to provide such a notice would discourage counterparties from consenting to assignments by derivatives dealers to related dealers and thereby impede and delay the implementation of Dodd-Frank. There is currently little express authority dealing with this question.

Specifically, the implementation of Dodd-Frank will necessitate the wholesale movement of books of OTC derivative positions between affiliates of derivatives dealers. Under standard ISDA documentation, these transfers will likely require counterparty consent. In SIFMA’s view, under current law, the resulting assumption of derivative positions by related affiliates should not cause the counterparties of the derivatives dealers to be deemed, for tax purposes, to have terminated their derivative contracts and entered into new ones. Nevertheless, certainty is needed on this point if counterparties are to consent to these transfers and the implementation of Dodd-Frank is to move forward in the manner that Congress has envisioned.

The IRS should provide certainty because it is not completely clear under Code interpretations that the assignments required as a practical matter to implement Dodd-Frank would not give rise to deemed exchanges for non-assigning counterparties. SIFMA warned of the serious tax consequences of a subsequent adverse conclusion by the IRS, which would cause counterparties to recognize gain or loss based on the value of their contracts at the time of the assignment. Also, the timing of the recognition could be asymmetric such that gains might be immediately recognized while losses were deferred under the wash sale or straddle rules

Under current law, a taxpayer realizes gain or loss from an exchange of property for other property that differs materially either in kind or extent. While a considerable amount of IRS authority speaks to when this occurs in the case of a debt obligation, relatively little authority currently speaks to when this occurs in the case of a derivative contract.

Since a debt obligation normally promises a fixed return of principal plus interest, reasoned SIFMA, the most important factor that serves to distinguish different kinds of debt instruments is the credit of the issuer, which goes to the likelihood that the otherwise fixed amounts will ultimately be paid. By contrast, a derivative contract normally provides for payments that vary directly or inversely with interest rates, currency values, and equity or commodity prices. The specific terms that govern the amount of these payments are by far the most important ones in determining the value of the position. The credit of the counterparty is comparatively insignificant, so long as it is adequate. Partly for these reasons, the IRS has consistently looked to the issuers of the assets underlying an option, rather than to the issuer of the option itself, in determining whether investments in options meet investment diversification requirements for various purposes of the Internal Revenue Code.

Moreover, while a debt obligation reflects only unilateral obligations of the borrower to the lender, a derivative contract reflects both rights and obligations on the part of each party and therefore generally has no net value at the time the contract is entered into. Bilateral derivative contracts are difficult to distinguish from other bilateral contracts such as leases and licenses that are entered into as a routine matter by businesses and individuals alike. There is no authority suggesting that parties to such agreements recognize gain or loss when their counterparties assign their rights and obligations to related parties, or even to unrelated parties in the course of, for example, a merger or acquisition.

Authorities under Section 1001 of the Code generally treat the assumption of a debt obligation by a new obligor as a modification sufficiently material in kind to cause the lender to be treated as having exchanged the old obligation for a new obligation. Private letter rulings antedating the promulgation of Reg. Sec. 1.1001-3 generally carved out an exception for cases of assumptions of debt obligations by related parties where there was no meaningful change in the credit behind the obligation.

In a reversal that has been criticized by some, Reg. 1.1001-3 appears to treat the assumption of a debt obligation by a related party as a taxable event regardless of whether there is a meaningful change in the credit behind the obligation, but it does not treat significant credit enhancements as resulting in a taxable event unless there is a meaningful change in payment expectations. By contrast, practitioners appear to have generally assumed that the assignment of a derivative contract to even an unrelated party does not result in a taxable event for the non- assigning counterparty absent a meaningful change in payment expectations.

SIFMA is concerned with the case where the assignment is to a related derivatives dealer. SIFMA believes that, absent other material changes in the terms of the contract, such an assignment does not rise to the level of a material difference in kind or extent that should cause the counterparty to be treated as having entered into a new transaction within the meaning of Section 1001 of the Code.

This conclusion is consistent with common business practice and also with whatever IRS authority has been promulgated to date pursuant to various private letter rulings, most of which has been directed towards allowing assumptions of debt obligations by related parties to accommodate routine business transactions. It is also consistent with the thrust of the regulations that have been promulgated under Reg. Sec. 1.1001-3. Whatever thinking lies behind the rule of Treas. Reg. Sec. 1.1001-3 that automatically treats a change in the obligor of a debt instrument as a deemed exchange, noted SIFMA, it should not be applied to the assignment of a derivative transaction, let alone to the assignment of a derivative transaction to a related party occurring in the context of a legitimate reorganization of business operations undertaken in connection with the implementation of Dodd-Frank.

No comments: