Reopening Structured Notes Report on an Emerging Financial Recovery, As Well As Movement on Other Important Policy Issues

Morrison & Foerster Quarterly News Volume 3, No. 1 March 2010 TaxTalk

IN THIS ISSUE 2 Health Care Act Revenue Raisers 3 HIRE Act FATCA Recap 6 Did You Catch That?

IRS Issues Industry Director 6 Directive on Total Return Swaps

Container Corp. v. Commissioner: 6 No U.S. Withholding Tax on Payment of Guaranty Fees by U.S. Subsidiary to Foreign Parent

Editor’s Note 7 Update on Contingent Capital As the financial crisis continues to ease, and capital markets continue to mend, policymakers can shift their attention to other The Classroom: important matters. In the first quarter of 2010, we continue to 7 Reopening Structured Notes report on an emerging financial recovery, as well as movement on other important policy issues. Of particular note, we report Press Corner on certain important revenue raisers in the Patient Protection 9 and Affordable Care Act and the Health Care and Education MoFo in the News Reconciliation Act of 2010 (together, the “Health Care Act”), 9 which pays for increased health care by, in part, codifying the economic substance doctrine (effective immediately) and increasing the Medicare tax on high-income earners (beginning Authored and Edited By in 2013), and in the Hiring Incentives to Restore Employment Act Thomas A. Humphreys (the “HIRE Act”), which codified the provisions of the Foreign Account Tax Compliance Act of 2009. In addition, we discuss Shamir Merali an IRS issued Industry Director Directive on Total Return Swaps Anna T. Pinedo and Container Corp. v. Commissioner (T.C., No. 3607-05, 134 T.C. Armin M. Gharagozlou No. 5), which held that guaranty fees paid to a foreign guarantor Remmelt A. Reigersman are foreign source and therefore not subject to U.S. withholding tax. We also provide an update on contingent capital. And, in our regular feature, The Classroom, building on past issues discussing capital markets offerings, we discuss the boundaries of reopenings as applied to structured notes. Morrison & Foerster Tax Talk Volume 3, No. 1 March 2010

test, the subjective business purpose and The technical explanation to the Health Health Care objective profit potential, together, should Care Act1 clarifies that this provision is be analyzed in order to determine whether not intended to change the tax treatment a transaction has substance, apart from its of certain basic business transactions Act Revenue tax consequences. merely because these transactions involve a choice between meaningful economic Raisers Codification alternatives and the choices are largely or entirely based on comparative tax The Health Care Act provides that advantages. Examples noted in the As discussed in our client alert, any transaction (including a series of technical explanation include: (i) the “Reconciliation Bill Codifies ‘Economic transactions) entered into after March 30, choice between capitalizing an entity with Substance’ Doctrine, Expands Medicare 2010 and to which debt or equity, (ii) the Taxes on High Income Earners and the economic choice between using Imposes Reporting Requirements on substance The Health Care Act a foreign corporation or doctrine is relevant a domestic corporation Certain Payments to Corporations,” is treated as further introduces a 3.8% to make a foreign on March 30, 2010, President Barrack having economic Medicare contribution tax investment, (iii) the Obama signed into law the Health Care substance only if on unearned income (i.e., choice to enter into a and Education Reconciliation Act of 2010, (i) the transaction income not from wages) transaction (or series of which supplements the Patient Protection changes in a of certain high income transactions) constituting meaningful way a (re)organization, and and Affordable Care Act, which was the taxpayer’s earners. (iv) the choice to use signed into law on March 23, 2010. To economic a related party in a pay for the new law, there are a number of position (the transaction. revenue raisers, which include codification objective test), and (ii) the taxpayer has of the economic substance doctrine and a substantial purpose for entering into Further, the technical explanation states such transaction (the subjective test). In that no inference is intended as to the additional Medicare taxes on high income applying the foregoing two tests, federal, proper application of the common law earners, which we recap below. state, or local income tax effects should economic substance doctrine and that the be disregarded. The determination of Health Care Act is additive to that doctrine. Economic Substance Doctrine whether the economic substance doctrine is relevant to a transaction is made in the Penalties Background same manner as if the provision codifying the doctrine had not been enacted. The Health Care Act introduces a The “economic substance doctrine” allows new strict liability penalty of 20% for the government to recast a transaction In determining whether the objective and an understatement attributable to a in a manner that reflects its substance, subjective tests are met with respect to a disallowance of claimed tax benefits or to disregard a transaction and its transaction, a profit potential is only taken by reason of a transaction entered into related federal income tax consequences, into account if the present value of the after March 30, 2010 lacking economic when the transaction has no economic reasonably expected pre-tax profit from substance or failing to meet the substance other than its intended tax the transaction is substantial in relation requirements of any similar rule of law consequences. There is a conflict in to the present value of the expected (and, therefore, it seems that the penalty the U.S. Circuit Courts of Appeal as to net tax benefits from the transaction. In would apply to both the statutory and the proper standard that should apply in calculating any pre-tax profit, fees and common law version of the economic determining when a transaction is to be other transaction expenses must be taken substance doctrine). The penalty is disregarded on the basis of the economic into account as expenses. Further, the increased to 40% if the taxpayer does substance doctrine. In applying the Health Care Act requires Treasury to issue not adequately disclose the relevant doctrine, the Fourth and D.C. Circuits have regulations requiring foreign taxes to be facts affecting the tax treatment of the adopted a two-prong “conjunctive” test. treated as expenses in determining pre-tax transaction on its tax return or in a Pursuant to this test, in order to disregard profits in appropriate cases. In addition, statement attached to the return. An a transaction for federal income tax achieving a financial accounting benefit amended tax return or a supplement to a purposes, the court must conclude that the that originates from a reduction of federal tax return is not taken into account if it is taxpayer, in entering into the transaction, income tax is not taken into account in filed after the taxpayer has been contacted fails both of the following requirements: determining whether the taxpayer meets for audit. Importantly, the “reasonable (i) subjective business purpose, and the above described subjective test. cause exception” is not available to avoid (ii) objective profit potential. The Sixth, the penalty. Therefore, as the technical Eleventh, and Federal Circuits have The economic substance provision only adopted the same test in a “disjunctive” applies to a transaction entered into by an fashion (i.e., if the taxpayer fails either 1 Technical Explanation of the Revenue Provi- individual if the transaction is entered into of the aforementioned prongs, the sions of the “Reconciliation Act of 2010,” as in connection with a trade or business or transaction at issue may be disregarded). amended, in combination with the “Patent an activity engaged in for the production of The Third, Ninth, and Tenth Circuits have Protection Act and Affordable Care Act,” as income. amended, Joint Committee on Taxation, March adopted a “unitary” test. Pursuant to this 21, 2010 (JCX-18-10).

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income as foreign earned income. President Obama signed into law the HIRE Health Care Act. We provide a recap of some of the Current and Future Federal Income Tax more notable provisions below, including Rates on Investment Income provisions which: (i) introduce a new Act Revenue 30% withholding tax on certain payments The chart below shows the maximum made to foreign entities that fail to comply Raisers federal income tax rate, assuming no with specified reporting or certification (Continued from Page 2) changes to current law,2 that applies to requirements, (ii) end the practice an individual earning in excess of the whereby U.S. issuers sell bearer bonds explanation points out, an opinion from threshold amount with respect to three to foreign investors by repealing the U.S. outside counsel or an in-house analysis categories of investment income for the bearer bond exception, and (iii) impose a would not protect a taxpayer from years 2010, 2011 and 2013 (taking into withholding tax on “dividend equivalents” imposition of the penalty. account the Medicare contribution tax paid under equity swaps. starting in 2013).3 Medicare Tax New Withholding Tax 2010 2011 2013 Under current law, both employers and The HIRE Act introduces a new 30% Dividends 15% 39.6% 43.4% employees are subject to a Medicare withholding tax on any “withholdable hospital insurance tax in an amount Interest 35% 39.6% 43.4% payment” made to a foreign entity unless equal to 1.45% of the wages paid to Long- 15% 20% 23.8% such entity complies with certain reporting requirements or otherwise qualifies for the employee. The employee level tax Term generally must be withheld and remitted to an exemption. A “withholdable payment” Capital the federal government by the employer. generally includes any payment of Gain As from January 1, 2013, the Health interest, dividends, rents, salaries, wages, Care Act increases the Medicare hospital premiums, annuities, compensations, insurance tax and imposes a Medicare The Tax Foundation (www.taxfoundation.org) remunerations, emoluments, and other contribution tax on unearned income, in provided a number of helpful examples fixed or determinable annual or periodical each case on certain high income earners. on the effect of these additional taxes on gains, profits, and income from sources certain taxpayers. For example, a single within the U.S. It also includes gross Medicare Hospital Insurance Tax taxpayer earning $200,100 in wages would proceeds from the sale of property that see a Medicare tax increase of 90 cents is of a type that can produce U.S.-source The Health Care Act imposes an additional ($100 excess wages multiplied by .9%). A dividends or interest, such as stock or debt tax of .9% on the wages of an employee single taxpayer earning $300,000 in wages issued by domestic corporations. Different over a specified threshold amount. The would see a Medicare tax increase of rules apply to foreign “financial institutions” threshold amount is $250,000 in the case $900 ($100,000 excess wages multiplied (“FFIs”) and to other foreign entities. of a joint return, $125,000 in the case by .9%). Married filers earning $5 million of a married individual filing a separate in investment income would be subject to The new 30% withholding tax on any return, and $200,000 for single filers. The a new Medicare unearned income tax of “withholdable payment” made to an FFI additional tax is also imposed on income $180,500 ($4.75 million excess unearned (whether or not beneficially owned by from self employment. income multiplied by 3.8%). such institution) applies unless the FFI agrees, pursuant to an agreement entered Medicare Contribution Tax into with Treasury, to provide information with respect to each “financial account” The Health Care Act further introduces held by “specified U.S. persons” and a 3.8% Medicare contribution tax on HIRE Act FATCA “U.S.-owned foreign entities.” The new unearned income (i.e., income not from disclosure requirements are in addition wages) of certain high income earners. Recap to requirements imposed by a “Qualified Specifically, in the case of an individual, Intermediary” agreement. the tax is imposed at a rate of 3.8% on As discussed in our prior client alert the lesser of (i) “net investment income,” “FATCA Provisions Enacted Into Law: The term FFI includes banks, brokers, or (ii) the excess of “modified adjusted New Withholding Tax, Ban on Bearer and investment funds, including private gross income” over the threshold amount Bonds, and Withholding on Dividend equity funds and hedge funds. A “financial specified in the preceding paragraph. “Net Equivalents,” on March 18, 2010, account” includes bank accounts, investment income” equals the taxpayer’s brokerage accounts, and other custodial gross investment income reduced by 2 Note that the Obama administration’s fiscal accounts, or an equity or debt interest in the deductions that are allocable to such year 2011 green book (available at http://www. the FFI (unless such interest is regularly income. Investment income generally treas.gov/offices/tax-policy/library/greenbk10. traded). The term “specified U.S. person” includes passive income such as interest, pdf) contains a proposal which would provide for includes any U.S. person, other than dividends, annuities, royalties, and rents a reduced rate of 20% on qualifying dividends. certain categories of entities, such as and capital gains. “Modified adjusted 3 The year 2012 is not included in the chart publicly-traded corporations and their gross income” is adjusted gross income since, under current law, the federal income tax affiliates, banks, mutual funds, real estate increased by the amount excluded from rates for that year are not scheduled to change investment trusts and charitable trusts. from the 2011 levels.

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HIRE Act Revenue Service (“IRS”) Forms 1099. represent gross proceeds from the sale of a capital asset). In such a case, a Rather than agreeing with Treasury to non-U.S. person would have to file a FATCA Recap act as a withholding agent in respect of U.S. tax return to obtain a full or partial (Continued from Page 3) reportable payments, an FFI may elect refund or credit. Similarly, a U.S. person to provide the withholding agents from with a foreign bank account on which it A “U.S.-owned foreign entity” for this which it receives payments with the receives payments that are withheld on, purpose is any entity that has one or more information necessary for the withholding presumably would have to claim a refund “substantial U.S. owners,” which generally agents to implement the new withholding or credit on its U.S. tax return. means (i) in the case of a corporation, if a tax (generally, information that discloses specified U.S. person, directly or indirectly, the extent to which payments made to The new withholding tax applies to owns more than 10% of the stock, by vote the electing FFI are allocable to accounts any withholdable payment made after or value, (ii) in the case of a partnership, subject to the 30% U.S. withholding tax). December 31, 2012, and, in the case if a specified U.S. person, directly or In addition, the agreement entered into of “obligations,” only with respect to indirectly, owns more than 10% of the between the electing FFI and Treasury payments on obligations issued after profits or capital interests, or (iii) in the must include a waiver of any right under March 18, 2012. Therefore, debt case of a trust, if a specified U.S. person is any tax treaty of the U.S. with respect to obligations (but not stock) outstanding on treated as an owner of any portion of the any amounts withheld under this election March 18, 2012, are grandfathered. trust under the grantor trust rules. provision. By entering into the agreement with Repeal of U.S. Bearer Bond Exception Further, the HIRE Act contains a provision pursuant to which an FFI may be treated In 1982, Congress passed the Tax Equity The new withholding as meeting the specified reporting and Fiscal Responsibility Act (“TEFRA”), tax applies to any requirements if (i) it complies with which restricts the issuance of debt procedures ensuring it maintains no U.S. instruments in bearer form. Under withholdable payment accounts and meets certain requirements TEFRA, issuers of debt instruments made after December 31, with respect to other FFIs maintaining in bearer form generally are denied 2012, and, in the case of an account with it, or (ii) such FFI is a deductions for U.S. federal income tax “obligations,” only with member of a class of institutions that purposes for interest paid with respect to respect to payments on would not be subject to these provisions. such debt instruments and are subject to obligations issued after Implementing procedures, requirements, an excise tax (equal to 1% of the principal and determinations in respect of this amount of the bonds times the number of March 18, 2012. provision would be determined by years to maturity). Various sanctions also Treasury in future guidance. apply to holders. The aforementioned sanctions, however, do not apply with The new withholding tax also applies respect to bearer debt instruments that are Treasury, the FFI agrees to (i) obtain to any withholdable payment made to issued under circumstances in which they information necessary to determine a non-financial foreign entity, unless are unlikely to be sold to U.S. persons. which accounts are U.S. accounts, (ii) the non-financial foreign entity provides These circumstances include an issuance comply with verification and due diligence the withholding agent with either (i) of foreign-targeted bearer debt instruments procedures as required by Treasury, a certification that it does not have a that complies with Treasury regulations (iii) annually report certain information substantial U.S. owner, or (ii) the name, referred to as “TEFRA C” and “TEFRA D.” regarding U.S. accounts (including U.S. address, and taxpayer identification account holder identification information number of each substantial U.S. owner. The U.S. imposes a 30% withholding tax and annual account activity information), This provision does not apply to payments on all U.S. source interest paid to non- (iv) withhold on “passthru payments” made to a publicly-traded non-financial resident aliens and foreign corporations. made to (1) recalcitrant account holders, foreign entity, or any of its affiliates. In 1984, Congress exempted “portfolio (2) other FFIs that do not enter into an interest” from the U.S. withholding tax in agreement with Treasury, and (3) FFIs If the beneficial owner of a payment is order to encourage investment in U.S. that have elected to be withheld upon entitled to treaty benefits, the withholding debt. Portfolio interest is any U.S. source (as further described below), (v) comply tax rate imposed on any withholdable interest other than interest received from with requests by Treasury for additional payment may be reduced or eliminated certain related parties, or interest earned information with respect to any U.S. by the provisions of an applicable tax by a bank on an extension of credit in the accounts, and (vi) attempt to obtain a treaty and such beneficial owner would be ordinary course of its lending business. waiver from the U.S. account holder if entitled to a partial or full refund or credit. In addition, Congress provided that debt any foreign law would otherwise prevent In addition, even if a treaty is not available, instruments in bearer form do not qualify the reporting of required information or the beneficial owner (other than an FFI) for the portfolio interest exemption (with alternatively close the account. Instead of a withholdable payment on which the the result that interest paid on such of reporting the necessary U.S. account 30% tax is withheld may otherwise be instruments is generally subject to the information, an FFI may elect to comply entitled to a full refund or credit of the 30% U.S. withholding tax) unless such with the reporting requirements that tax (e.g., because payments are eligible instruments are issued in compliance with apply to U.S. financial institutions, which for the portfolio interest exemption or the foreign-targeted requirements imposed generally means reporting on Internal 4 Morrison & Foerster Tax Talk Volume 3, No. 1 March 2010

required for registered debt. However, a combination thereof. Transactions HIRE Act the HIRE Act includes a provision giving involving swaps rely on a Treasury Treasury the authority to determine that regulation that provides that the source of certification as to non-U.S. beneficial any payments made pursuant to the swap FATCA Recap ownership is not required to qualify for is determined according to the country (Continued from Page 4) the portfolio interest exemption from of residence of the person receiving the by TEFRA. withholding tax on payments of interest payment. Although substitute dividend on certain registered debt obligations. In payments made under a stock-lending Many U.S. issuers have European addition, the HIRE Act codifies IRS Notice agreement are sourced in the same medium-term note or other foreign- 2006-99 providing that debt obligations manner as the dividends with respect to targeted programs pursuant to which they cleared through dematerialized book-entry the underlying stock (and would therefore issue bearer notes to non-U.S. investors. systems (such as JASDEC in Japan, or be U.S. source if made with respect to These issuances comply with TEFRA other book-entry systems specified by stock of a U.S. corporation), transactions regulations and, as such, the instruments the Treasury) would be treated as being involving stock lending rely on a decade- are not subject to the sanctions described issued in registered form. It seems that old IRS Notice (Notice 97-66) to avoid U.S. above or to U.S. withholding tax. In these provisions are aimed at giving dividend withholding tax. addition, many non-U.S. issuers include Treasury the authority to prescribe TEFRA restrictions in their debt offerings rules pursuant to which U.S. issuers The HIRE Act treats as a U.S.-source sold outside the U.S. to ensure that they would be able to raise debt capital from dividend any “dividend equivalent” are not subject to the TEFRA excise tax. jurisdictions where bonds are typically for purposes of U.S. withholding tax held in dematerialized form or where provisions. A “dividend equivalent” is (i) Some foreign investors are legally any substitute dividend (made pursuant to jurisdictions, e.g., barred from certifying a securities-lending or “repo” transaction), Switzerland, do not as to residency (e.g., (ii) any amount paid pursuant to a permit their residents The HIRE Act treats Switzerland). Whether “specified notional principal contract,” to certify as to their as a U.S.-source Treasury would, in and that is contingent on, or determined identity. Accordingly, fact, exercise such by reference to, the payment of a U.S.- there are special dividend any “dividend authority remains to source dividend, and (iii) any amount that rules in the TEFRA equivalent” for be seen. the Treasury determines is substantially regulations that purposes of U.S. similar to a payment described in (i) and permit offerings The HIRE Act (ii). to be sold into withholding tax preserves the those jurisdictions provisions. exception to the A specified notional principal contract in bearer form if excise tax for bearer is any notional principal contract if (i) in certain additional bonds issued under connection with entering into the contract, requirements are TEFRA-compliant any long party (i.e., the party entitled to met. procedures. As a result, foreign issuers of receive the dividend related payment) a “foreign-to-foreign” bearer debt offering transfers the underlying security, (ii) in The HIRE Act ends the practice by U.S. that is TEFRA-compliant would not be connection with the termination of the issuers of selling bearer bonds to foreign subject to the excise tax. contract, any short party (i.e., any party investors under TEFRA C and TEFRA that is not a long party) transfers the D. Thus, with respect to U.S. issuers The repeal of the U.S. bearer bond underlying securities to any long party, of foreign-targeted bearer bonds, the exception applies to debt obligations (iii) the underlying security is not readily HIRE Act repeals the exception to a issued after March 18, 2012. Therefore, tradable on an established securities denial of interest deduction for interest debt obligations in bearer form outstanding market, (iv) in connection with entering on bearer bonds. In addition, interest on March 18, 2012 are grandfathered. into the contract, any short party to the paid on such bonds would no longer contract posts the underlying security as qualify for treatment as portfolio interest, “Dividend Washing” collateral, or (v) the Treasury identifies thereby subjecting such interest to a 30% the contract as a specified notional withholding tax, and any gain realized by a In September 2008, the Senate Permanent principal contact. In addition, unless holder of such bonds would be treated as Subcommittee on Investigations released the Treasury determines that a notional ordinary income. a report entitled “Dividend Tax Abuse: How principal contract is of a type that does Offshore Entities Dodge Taxes on U.S. not have the potential for tax avoidance, As a result, U.S. issuers will have to revise Stock Dividends.” The report described any notional principal contract pursuant to their existing securities offering programs, a range of transactions employed by which payments are made after March 18, including medium-term note programs, financial institutions aimed at enabling 2012, will be a specified notional principal to prohibit bearer debt. U.S. issuers non-U.S. clients to avoid U.S. withholding contract. may have a harder time raising capital in taxes on dividends paid with respect foreign jurisdictions to the extent investors to U.S. securities. As described in the To address the concern with respect to the in those jurisdictions are unwilling to report, U.S. withholding taxes on dividends cascading effect of such a dividend provide the non-U.S. beneficial ownership are avoided through the use of either withholding tax, the HIRE Act includes a certification (e.g., IRS Form W-8BEN) swaps or stock-lending transactions, or provision pursuant to which the Treasury

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the subsequent decrease in estimated which would be subject to U.S. withholding HIRE Act payments.) From what we can tell, this tax. The financial institution, as a financial revenue accelerating budget device has intermediary, would be considered a been used before, although the 173.5% withholding agent with respect to those FATCA Recap number appears to be a record. One payments and would be liable for the (Continued from Page 5) imagines that in 2014 large corporations withholding tax if it failed to withhold and will be quite distressed to learn that they remit the withholding tax to the IRS. To may reduce the tax if one or more of the are being asked to make a short-term loan avoid this liability, the financial institution dividend equivalents is subject to tax and to the IRS. would be expected to argue that the to the extent the taxpayer establishes that form of the swap transaction should be the tax has been paid on another dividend respected. It is not possible to predict equivalent in the chain or if Treasury the extent of the impact of the IDD on determines such reduction is appropriate IRS Issues the equity swap market or the ultimate to address the role of financial outcome of the transactions described intermediaries. For purposes of this in the IDD if litigated. We understand, provision, an actual dividend payment is Industry Director however, that a number of financial treated as a dividend equivalent. institutions in the U.S. are already under Directive on audit on this issue. This provision applies to payments of “dividend equivalents” made on or after Total Return September 14, 2010 (i.e., the 180th day after enactment of the HIRE Act). Swaps Container Therefore, these provisions apply to existing swaps. On January 14, 2010, the IRS issued an Industry Director Directive on Total Corp. v. Return Swaps Used to Avoid Dividend Withholding Tax (“IDD”). The IDD provides Commissioner: audit guidance to IRS field agents auditing Did You Catch financial institutions and contains six forms No U.S. of Information Document Requests for IRS field agents to use in order to obtain Withholding Tax That? information from financial institutions that Keen readers of fine print may have have engaged in equity swap transactions. on Payment noticed §561 of the HIRE Act and §1410 The purpose of the IDD is to assist IRS of the Health Care and Education field agents in uncovering and developing of Guaranty Reconciliation Act of 2010. Those cases related to total return swap sections amend §6655 of the Internal transactions that may have been executed Fees by U.S. Revenue Code which provides for the in order to avoid U.S. withholding tax with payment by corporations of estimated respect to U.S. source dividend income Subsidiary to taxes. Generally speaking, large paid to non-U.S. persons. It seems that corporations (those with at least $1 billion the IRS is looking to assert deficiencies of assets) must pay estimated tax equal against the financial institutions that Foreign Parent facilitated the equity swap transactions, to 100% of their current year federal In resolving what has long been an income tax in four installments during the in their capacity as a withholding agent, rather than against the non-U.S. persons uncertain issue, the Tax Court held, in an taxable year. Putting §561 and §1410 opinion dated February 17, 2010, that a together it appears that for July, August, that have the substantive tax liability. The IDD includes a description of several U.S. corporate subsidiary of a Mexican and September 2014 large corporations parent company was not required to will have to pay 173.5% of the normal transactions perceived to be potentially abusive involving equity swaps such withhold U.S. federal income taxes from required estimated tax installment to the the guaranty fees the subsidiary paid to its IRS. The provision reverses itself in the as: cross-in and cross-out transactions, cross-in and interdealer broker out parent in connection with guaranteeing its next quarter. Why? Looking, in particular, debt. at §1410 of the Health Care and Education transactions, cross-in and foreign affiliate out transactions, and “fully synthetic” Reconciliation Act of 2010, we surmise The U.S. imposes a 30% withholding tax that 2014 marks the end of the 5-year transactions. The IRS encourages its field agents to develop cases where it on all interest, dividends, rents, salaries, reconciliation period (the federal fiscal year wages, premiums, annuities, ends on September 30). For government could be concluded that, in substance, the non-U.S. person retained ownership compensations, remunerations, budget purposes, approximately $8 billion emoluments, and other fixed or of revenue is raised through §1410 in of the U.S. equities referenced by the swap transactions. As such, the non- determinable annual or periodical the five year budget window. (On the (“FDAP”) gains, profits, and income that other hand, over the 10-year horizon U.S. person would be treated as having received a payment of a U.S. source are U.S. source and paid to non-resident used to judge the health care legislation’s aliens and foreign corporations. Treasury overall impact, the increase is offset by dividend, instead of a payment under a swap which would be foreign source, and regulations provide sourcing

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U.S. source since they were analogous to convertible into a fixed number of Lloyds Container interest and paid by a U.S. corporation. ordinary shares if Lloyds’ consolidated core Therefore, according to the IRS, the fee Tier 1 ratio falls below 5%. In the Lloyds Corp. v. payments would be subject to U.S. federal offering, the contingent capital instruments withholding tax. The U.S. subsidiary were offered as part of an exchange for admitted that the guaranty fees were poorly performing bonds. So it was not Commissioner: FDAP income, but argued that the fees clear how a new offering of contingent (Continued from Page 6) were not U.S. source (and therefore not capital instruments would be received by subject to U.S. federal withholding tax) investors and the yield that investors would since they were for services performed in exact. rules for certain, but not all, categories of Mexico. FDAP income. For example, Treasury However, in March, Rabobank Nederland, regulations provide that interest is sourced The Tax Court reasoned that the parent’s the Dutch bank, issued €1.25 billion of according to the place of residence of the creditworthiness, its goodwill, and its new contingent capital notes (Rabobank payor and that assets produced the “Senior Contingent Notes due 2020”). The payments for guaranty fees and found notes were well received by investors, services are that such fees were more having an order book size of €2.6 billion sourced according Reopening a debt issue analogous to payments and a yield of 6.875% (some expected that to where the can have significant for the performance for the notes to sell, a higher yield would services are of services because be required). In general, the notes act tax consequences, they were payments for like regular fixed rate bonds but provide performed. To the particularly where the extent no sourcing incurring a contingent that if a trigger event occurs—i.e., that the rules are set forth additional notes, treated future obligation. The bank has an equity capital ratio of less in Treasury as debt instruments for court then concluded 7%—the redemption price of the notes regulations, case U.S. federal income tax that since the parent will be written down by 75% to 25% of the was located outside the notional amount. Accordingly, the notes law provides that purposes, are issued the source of any U.S., the guaranty fees have contingent principal dependent upon such FDAP with original issue were not U.S. source and the equity capital reserves of the bank. income would discount (“OID”). therefore not subject to have to be U.S. withholding tax. determined by analogy. In Bank The Classroom: of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982), the court held that a bank’s Update on commissions received for acceptance and Reopening confirmation of letters of credit were sourced by analogy to interest because the Contingent Structured bank substituted its credit for that of the foreign bank issuing the letters of credit. Capital However, commissions received pursuant Notes to transactions, in which the bank As we previously discussed in our prior As discussed in our prior issue of MoFo confirmed that the documentation issue of MoFo Tax Talk and elsewhere Tax Talk (see MoFo Tax Talk, Volume presented by the beneficiary conformed to (see e.g., MoFo Tax Talk, Volume 2, Issue 2, Issue 1), debt issues are often the terms of the letter of credit, were, 4, “Contingent capital instruments,” and “reopened,” meaning that an issuer according to the court, sourced by analogy “Is it a bird? A plane? Exploring contingent issues an additional tranche of notes to income from services. Until now, it was capital”) contingent capital instruments are (“additional notes”) at some point after the not clear what guaranty fee payments were a novel hybrid security intended to provide original issuance (“original notes”). The analogous to. a buffer for financial institution issuers additional notes bear the same terms during times of stress, when financial and security identification code (e.g., In Container Corp., a Mexican corporation institutions may find it difficult to access the CUSIP number) as the original notes. guaranteed its U.S. subsidiary’s notes, market in order to bolster their regulatory Generally speaking, the economic motive which were issued in connection with an capital levels. acquisition. The U.S. subsidiary paid behind a reopening is to give existing holders a more liquid instrument and to its Mexican parent a guaranty fee equal The first contingent capital instrument was give the issuer a lower cost of financing. to 1.5% of the outstanding principal Lloyds’ Enhanced Capital Notes issued To achieve these goals, the issuer’s balance of the notes each year. The last November. A Lloyds Banking Group intent is that the original notes and the U.S. subsidiary did not withhold any U.S. affiliate issued £7.5 billion in the form of additional notes be indistinguishable and, federal income taxes from the fees. contingent capital called “enhanced capital therefore, completely fungible. Reopening notes” to existing Tier 1 and Upper Tier 2 a debt issue can have significant tax The Internal Revenue Service (“IRS”) security holders. The enhanced capital consequences, particularly where asserted that the guaranty fees were notes have a ten year term and pay fixed, the additional notes, treated as debt FDAP income and should be considered non-deferrable interest. The notes are

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additional notes may taint the original notes on their issue date (or, as is often The Classroom: notes, with the IRS treating both the the case, if the original securities were (Continued from Page 7) original notes and the additional notes as issued with no more than a de minimis having been issued with OID in the hands amount of OID, their coupon rate). instruments for U.S. federal income tax of a purchaser who buys notes after the purposes, are issued with original issue reopening. Alternatively, a reopening of debt discount (“OID”). instruments (regardless of whether the To be fungible from a tax standpoint, reopening occurs within six months or not) Taxpayers are required to currently accrue the reopening must satisfy one of three is treated as a qualified reopening if: OID on a constant yield basis for any debt tests: the original notes and the additional instrument that is issued with more than a notes must be part of the same “issue” a. the original notes are publicly traded, de minimis amount of OID. OID generally (under the 13-day rule discussed below), and arises where a note is originally issued at or the additional notes must be part of a a discount and is an attribute of the note “qualified reopening” of the original notes b. the additional notes (treated as a itself (i.e., OID “travels” with the note and (under either one of the two alternative separate issue) are issued with no does not vary depending on whether an tests discussed below). Under each of more than a de minimis amount of OID. original investor or a secondary market the three tests, a precondition is that the investor holds the note). In contrast, additional notes must have terms that are “market discount” generally arises when in all respects identical to the terms of the Publicly Traded Test a secondary-market investor purchases a original notes. debt instrument at a discount after original Applicable regulations provide detailed rules that define when notes are treated issue. Market discount generally is not 13-Day Rule taxable currently as it accrues, unless the as “publicly traded.” The most common holder so elects. scenarios are (a) the notes are listed on Under applicable regulations, an “issue” a national securities exchange, or (b) Thus, where the original notes are not of debt instruments includes all debt the notes appear on a system of general issued with OID, but where the additional instruments that: circulation (including a computer listing notes are priced at a discount in excess disseminated to subscribing brokers, of the statutory de minimis amount a. are issued either pursuant to a common dealers, or traders) that provides a (e.g., because interest rates have risen plan or as part of a single transaction or reasonable basis to determine fair market after original issue), a holder generally a series of related transactions, and value by disseminating either recent price would prefer the original notes and the quotations (including rates, yields, or additional notes to be fungible from a tax b. are issued within a period of 13 days other pricing information) of one or more standpoint, so that the additional notes beginning with the date on which the identified brokers, dealers or traders, or (like the original notes) are not treated as first debt instrument that would be part actual prices (including rates, yields, or having been issued with OID, but rather of the issue is sold to a person other other pricing information) of recent sales are treated as being acquired by holders than a bond house, broker, or similar transactions (a “quotation medium”). A at a market discount. The reopening rules person or organization acting in the quotation medium does not include a discussed below police the boundaries capacity of an underwriter, placement directory or listing of brokers, dealers or within which the additional notes may be agent, or wholesaler. traders for specific securities that provides treated as fungible with the original notes neither price quotations nor actual prices in this manner. of recent sales transactions. Bloomberg Qualified Reopening and/or TRACE may qualify as a quotation If the original notes and the additional medium for a particular issuance if there notes do not meet the requirements The regulations provide rules for two types is sufficient trading frequency and volume described below, the tax law treats the of qualified reopenings. Under the first within the testing period. Even if any additional notes as a fresh issuance issued rule, a reopening of debt instruments is particular tranche of notes does not satisfy with OID and, accordingly, the original treated as a qualified reopening if: the requirements of (a) and (b) above, they notes and the additional notes would not may nonetheless be treated as publicly be fungible from a tax standpoint. If the a. the original notes are “publicly traded” traded under additional tests that are more original notes and the additional notes (see discussion below), fact specific. are nonetheless issued so that they are indistinguishable (i.e., issued with the b. the issue date of the new notes (treated Reopening Structured Notes same terms and CUSIP number) it would as a separate issue) is not more than be impossible for secondary market six months after the issue date of the Whether an issue of structured notes (for purchasers or, for that matter, the IRS, original notes, and a taxonomy on structured notes, see our to trace securities through the chain of prior issue of MoFo Tax Talk, Volume 1, intermediate ownership and determine c. on the pricing date of the reopening Issue 1) may be reopened without the whether their notes were issued as part (or, if earlier, the announcement date), above described adverse U.S. federal of the original issuance (issued without the yield of the original notes (based income tax consequences generally OID) or the additional issuance (issued on their fair market value) is not more depends on the characterization of the with OID). There is a risk, then, that the than 110% of the yield of the original note and the technical rules that apply to

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note and the prevailing market conditions As discussed in one of our prior issues The Classroom: at that time. As such, the reopening of of Tax Talk (see MoFo Tax Talk, Volume (Continued from Page 8) Type 3 notes may be subject to the same 1, Issue 4) in September of 2008, J.P. considerations as the reopening of Type 1 Morgan Chase and Co. (“JPM”) purchased the structured note. notes or of Type 2 notes. all of the assets of Washington Mutual (“WaMu”) for approximately $1.9 billion and assumed its deposit liabilities and Type 1 notes are generally treated either debt (including covered bond obligations). as fixed rate debt instruments, variable A controversy later ensued with respect rate debt instruments (“VRDIs”), or Press Corner to who was entitled to WaMu’s tax contingent payment debt instruments losses—the bank holding company (and (“CPDIs”). The discussion above The U.S. tax authorities will soon launch its creditors), or JPM. The Wall Street regarding the 13-day rule generally applies another prosecution against a foreign Journal recently reported (see Scott Thurm to all structured notes that are treated as bank for facilitating offshore tax evasion, a and Dan Fitzpatrick, “Tax-Break Battle Type 1 notes. In addition, the qualified la the case against Swiss bank UBS AG, Flares,” WSJ Online, March 24, 2010) reopening rules described above generally according to an IRS agent speaking with that JPM could benefit from a tax refund apply to all Type 1 notes that are treated Reuters. (See, e.g., Pascal Fletcher, “IRS: of up to $1.4 billion from its acquisition of as either fixed rate debt instruments or as new UBS-style foreign bank prosecution the assets of WaMu due to the economic VRDIs. However, the qualified reopening ‘shortly’,” Reuters, http://www.reuters.com/ stimulus bill, which provides for a provision rules do not apply to Type 1 notes that are article/idUSTRE62E4OW20100315?feedT that relaxes the carryback limitation of net considered CPDIs for U.S. federal income ype=RSS.) Last year, UBS was accused operating losses of corporations to up to tax purposes. Therefore, an issue of Type of aiding and abetting offshore tax evasion five years. The carryback relief, however, 1 notes treated as CPDIs can only be by U.S. citizens. UBS settled two U.S. restricted TARP recipients from receiving reopened for tax purposes if the reopening lawsuits against it, agreeing to pay a $780 the benefit. Although JPM was a TARP meets the requirements of the 13-day rule. million fine and also agreeing to turn over recipient, WaMu was not, possibly allowing If additional notes in an issue of CPDIs account records to U.S. authorities. The JPM to reap the rewards of the new law are issued outside of the 13-day rule, such threat to turnover account records led to through its acquisition of WaMu assets. additional notes will have a different issue many prior undeclared accounts being The FDIC, however, is not yet signed off date, a different issue price and a different disclosed to U.S. tax authorities through on permitting JPM to share in the refund. adjusted issue price from the original a specially tailored voluntary compliance notes. In addition, the issuer would be program, which expired on October 15, required to provide a new “comparable 2009, and, the pre-existing IRS voluntary yield” and “projected payment schedule” compliance standards. with respect to the additional notes. MoFo in the Further, the additional notes would have Charles Rangel (D – New York) temporarily to be distinguished from the original notes stepped down as chairman of the House (e.g., through a different CUSIP number). Ways and Means Committee until a News continuing probe by the House ethics committee into ethics violations concludes. On January 12, 2010, West Legalworks Type 2 notes are not treated as debt presented a webinar on “Foreign Private instruments for U.S. federal income tax Rangel has been scrutinized for possible ethics violations for corporate payments, Issuers: Raising Capital and Maintaining purposes and, under current law, a holder Compliance.” Anna Pinedo and David of a Type 2 note is not required to accrue failure to pay taxes, failure to report assets on federal disclosure forms, misuse of Lynn of Morrison & Foerster LLP any income (including OID or market discussed the securities law aspects of discount). As a result, the above described rent-controlled apartments in New York, and improper solicitation of donations for financing strategies of foreign issuers, concern regarding the conversion of OID including private placements of debt into market discount does not exist, and the Charles B. Rangel Center for Public Service at the City College of New York. securities and Rule 144A offerings, and U.S. federal income tax law does generally recent developments, such as a number not impose any restrictions on reopening Sander Levin (D – Michigan) has been elevated to chairman in Rangel’s absence. of amendments to the rules relating to Type 2 notes. foreign private issuers which are intended to enhance the information available to To the extent a Type 3 note is treated In what can be described as wishful thinking, in a vote of 386 to 33, the House investors under the SEC’s Foreign Issuer as an income-bearing single financial Reporting Enhancements. contract, the same considerations as to passed H.R. 946, the “Plain Writing Act of 2010,” which would require government the reopening of Type 2 notes apply and On January 21, 2010, the American U.S. federal income tax law generally agencies to write in plain English. The term ‘‘plain writing’’ means writing that “the Law Institute/American Bar Association does not impose restrictions on reopening. presented a webinar on “PIPES and However, to the extent a Type 3 note intended audience can readily understand and use because that writing is clear, Registered Direct Offerings.” Anna Pinedo is treated as a unit consisting of a debt and James Tanenbaum of Morrison & component and a derivative, an analysis concise, well-organized, and follows other best practices of plain writing.” Notably, Foerster LLP discussed the advantages of a reopening of a Type 3 note will and disadvantages of PIPE transactions depend on the facts and circumstances, however, the Plain Writing Act of 2010 would not apply to regulations. (i.e., private investments in public equity on the agreed upon treatment between in which a fixed number of securities are the issuer and the holder of the particular

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notes at some point after original issue. (Amendments to FASB Interpretation No. MoFo in the The additional notes bear the same terms 46(R)), which would, in general, among and security identification code (e.g., other things, bring securitizations back CUSIP number) as the original notes. The onto the balance sheet of many issuers. News issuer’s intent is that the original notes and (Continued from Page 9) the additional notes be indistinguishable On February 22, 2010, Thomas and, therefore, completely fungible. Anna Humphreys of Morrison & Foerster LLP sold to accredited institutional investors) Pinedo and Remmelt Reigersman of presented a seminar entitled “European and registered direct offerings (i.e., fully Morrison & Foerster LLP discussed the Tax College” on the U.S. taxation of registered transactions sold to select securities law and tax requirements and financial instruments at the Katholiekke institutional investors) as potential capital limitations of such re-openings. Universiteit Leuven in Leuven, Belgium. raising alternatives, and the corporate and Thomas Humphreys discussed the securities law aspects of such offerings, On February 3, 2010, International taxation of the basic building blocks including shelf registrations and Rule Financial Law Review presented a of more complex financial instruments 144A. webinar on “U.S. and E.U. Hybrid Capital.” (i.e., stock, debt, options, forwards and Panelists included Thomas Humphreys notional principal contracts), more complex On January 21, 2010, Morrison & Foerster and Anna Pinedo of Morrison & Foerster instruments such as hybrid securities LLP presented “Structured Notes Tax Boot LLP and Steve Sahara and Annabel Daws- and structured notes, securitizations, and Camp” in the New York Office. Thomas Chew of Calyon. Panelists discussed recent developments in this area. Humphreys and Shamir Merali of Morrison recent developments with respect to hybrid & Foerster LLP discussed the U.S. federal securities in light of the financial crisis, On February 23, 2010, BNA presented a income taxation of structured notes, including developments with respect to the webinar on “Capital Raising Alternatives for including Type 1 notes (those treated as regulatory framework for Tier 1 products Foreign Issuers; Update on Developments debt instruments), Type 2 notes (those and contingent capital. Involving Foreign Private Issuers.” Anna treated as non-debt derivative financial Pinedo of Morrison & Foerster LLP contracts), and Type 3 notes (those that On February 4, 2010, American Law discussed the securities law aspects of issuers have treated as a single non-debt Institute/American Bar Association private placements of debt securities derivative financial contracts or bifurcated presented a webinar on “At-the-Market and recent developments, such as those as deposits and non-debt derivative Offerings.” An at the market offering (also that are part of the SEC’s Foreign Issuer contracts). referred to as an “equity distribution” Reporting Enhancements. or “equity dribble out” program) is a On January 29, 2010, Association of continuous offering that allows an issuer On March 4, 2010, Morrison & Foerster German Pfandbrief Banks presented “Why to issue securities into the secondary LLP, in conjunction with Moody’s Investors the U.S. Needs Covered Bonds.” Jerry market over a period of time at the publicly Service and UBS Investment Bank, Marlatt of Morrison & Foerster LLP joined available bid price, rather than at a fixed or presented “Hybrid Capital.” Panelists the panel to discuss the advantages of negotiated price of a traditional securities include Thomas Humphreys and Anna covered bonds in the United States and offering. MoFo partners Anna T. Pinedo Pinedo of Morrison & Foerster LLP, recent developments. Covered bonds are and David Lynn discussed the benefits of Barbara Havlicek of Moody’s Investors debt instruments of an issuer (e.g., a bank) such a program over traditional securities Service and Anthony Ragozino of UBS in which an investor in the bonds has offering programs, which may include, for Investment Bank. Panelists discussed recourse against the issuer and a specified example, increased flexibility by the issuer recent hybrid securities developments, pool of collateral (the “cover pool”), which, in the amount and timing of securities including Tier 1 products and contingent in general, consist of high quality assets offered, lower underwriting costs, and capital. of the issuer. These instruments are a minimized marketing efforts. Panelists form of on-balance sheet financing and also discussed advantages associated with On March 5, 2010 the Federal Bar provide a possible source of alternative at-the-market offerings, documentation, Association Section on Taxation held financing by banks in lieu of securitization. different marketing and sales mechanisms, its 34th Annual Tax Law Conference in For a further discussion of covered bonds, and Regulation M and other securities law Washington D.C. Thomas Humphreys of see, e.g,. Anna Pinedo, “Covered Bonds considerations. Morrison & Foerster LLP, staff members in the U.S.,” Practical Law The Journal, from the Joint Committee on Taxation February 2010, available at http://www. On February 9, 2010, West Legalworks and House Ways and Means Committee, mofo.com/files/Publication/ae238f08-a5a7- presented a webinar entitled “How Will as well as a Treasury Department 4394-b944-f91620717f52/Presentation/ Regulatory and Accounting Reform representative presented on the “Latest PublicationAttachment/6ae8aeb5-02ad- Change Securitization?” Thomas Developments in U.S. Offshore Tax 4503-ba0e-fa0f48ba5045/Article-%20 Humphreys and Jerry Marlatt of Morrison Compliance.” The panel discussed the Covered%20Bonds%20in%20the%20US. & Foerster LLP, and Thomas Rees provisions of FATCA, such as the new pdf. of FTI Consulting, discussed various withholding tax on withholdable payments, proposed and actual accounting reforms the repeal of the bearer bond exception, On February 2, 2010, West Legalworks to the securitization market, including and the tax treatment of dividend presented a webinar on “Re-openings.” As the proposed reforms by the current equivalent payments, as discussed above discussed above in The Classroom, debt administration, and FASB 166 (Accounting under “HIRE Act FATCA Recap.” issues are often “re-opened,” meaning that for Transfers of Financial Assets) and 167 an issuer issues an additional tranche of

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Anna Pinedo and Thomas Humphreys of international securities offering work on MoFo in the Morrison & Foerster LLP, Andrea O’Toole behalf of issuers and underwriters, and of Nomura Securities, Darren Greenberg of counsel on the Debt and Equity Linked Royal Bank of Scotland, and Deal of the Year, on the Equity Deal of the News Jeffrey Robins of Cadwalader were Year, and on the Securitization Deal of the (Continued from Page 10) panelists on a presentation entitled Year. International Financial Law Review On March 18, 2010, Practising Law “Legal, Regulatory, Compliance Summit: is a leading publication for in-house Institute presented a webinar on “Foreign How the Industry Is Prepared for the counsel and practitioners in the financial Issuers: Accessing the U.S. Markets.” New Litigation and Regulatory Climate.” markets. Anna Pinedo and David Lynn of Morrison Panelists discussed securities law, tax, & Foerster LLP discussed various and compliance issues for structured alternatives to initial public offerings by products in response to new litigation and foreign issuers, including Rule 144A the regulatory climate after the fallout of offerings, institutional debt private Lehman Brothers. placements, Reg S offerings, and ADR programs. On March 25, 2010, Morrison & Foerster LLP was recognized with four awards at On March 25, the Structured Products the International Financial Law Review Association held its 7th Annual Conference Americas Awards ceremony. Morrison at New York City’s Grand Hyatt Hotel. & Foerster LLP was selected as “Equity Team of the Year” for its U.S. and

Contacts United States Federal Income Tax Law Corporate + Securities Law

Thomas A. Humphreys Shamir Merali Anna Pinedo Lloyd Harmetz (212) 468-8006 (212) 336-4149 (212) 468-8179 (212) 468-8061 [email protected] [email protected] [email protected] [email protected] Remmelt A. Reigersman Armin M. Gharagozlou (212) 336-4259 (212 ) 336-4327 [email protected] [email protected]

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