Editor's Note

Q2 2019 started out with a great deal of hope in the world of capital markets taxation. We were greatly looking forward to the US Supreme Court granting certiorari in Estate of McKelvey v. Comm'r and ultimately helping tax practitioners understand how to apply some fairly complicated Internal Revenue Code (the "Code") sections including sections 1234A and 1259 of the Code. Unfortunately, the quarter ended not with a bang but a whimper, when the Supreme Court denied certiorari in McKelvey. Accordingly, we are left with the Second Circuit decision in McKelvey, which among other things, finds that an obligation on a variable pre-paid forward contract ("VPFC") is not "property" for purposes of section 1001 of the Code and also that whether the number of shares in a VPFC is "substantially fixed" can be based on a probability analysis (in McKelvey the probability that there would be any variation was less than 15%). Unfortunately, McKelvey's estate will end up back in Tax Court to figure out the amount of tax actually owed.

For the rest of the year, we can look forward to a number of projects that are on the Internal Revenue Service's ("IRS") to do list, otherwise known as the business plan.

For example, the IRS added the tax issues surrounding LIBOR replacement which is becoming more complicated by the day.

Replacing an existing LIBOR rate in a note or derivative with a replacement when/if LIBOR ceases to be published raises complex issues under section 1001 of the Code as well as other Code sections, and we are steeling ourselves to give special coverage to those LIBOR replacement provisions in the next issue of CMTQ.

This issue of CMTQ also covers the US federal income tax consequences of negative interest, a recently proposed financial transactions tax, a helpful real estate investment trust ("REIT") private letter ruling applying the publicly offered exception to the preferential dividend rule to a subsidiary of publicly offered REIT, and more.

Tax Consequences of Negative Interest Rates

A few years back we thought negative interest rates were just a fad and would soon disappear when the global economy recovered. However, today over $13 trillion of debt worldwide is trading with negative interest rates.1 The Netherlands, Germany, Switzerland, France and Japan all borrow at negative interest rates through the yield curve.

A few years back we also thought negative interest wouldn't be around long enough for the IRS to issue guidance. We were both wrong and right. Negative interest has persisted and the universe of negative interest debt instruments has expanded, not disappeared. On the other hand, the IRS still hasn't cared enough to issue guidance on the tax treatment of negative interest.

What is negative interest? It is actually quite simple: US investor A ("A") buys a €100 German government bond. The bond has a five-year term. The bond pays A no interest and in five years Germany pays A €99. There is €1 of negative interest.

For federal income tax purposes, there is no authority on how negative interest is treated. There are various possibilities. For example, the negative interest might be seen as a fee of €1 paid by A to have the German government keep its money safe. Or, it might be treated as bond premium. Before the advent of negative interest when Germany paid back €99 and A lost €1 this would be treated as a capital loss to A because retirement of the bond is treated as a sale or exchange under section 1271 of the Code.2 A could not amortize the €1 premium because Code section 171 provides that bond premium is amortized by offsetting it against qualified stated interest on the bond. Here, there is none.

In 2014, however, the IRS adopted regulations to change this result. Treas. Reg. section 1.171- 2(a)(4)(C) provides that the repayment of a debt instrument results in a Code section 171 ordinary deduction for unamortized bond premium in a debt instrument's final accrual period. With a negative interest debt instrument, there will be unamortized bond premium in the final accrual period by definition. So, in our example, at the bond's maturity, A would be entitled to a €1 ordinary deduction.

This is not a case of the IRS being unusually ahead of the curve. Instead, we understand this provision was added to the regulations because a few years back short-term Treasury bills were actually sold by brokers at a negative interest rate and the government wanted to protect people who bought government debt. At the time, we were also told the US Treasury did not have the systems in place to charge debt holders negative interest rates; we have no idea whether that is still the case today.

Another issue is whether payments of negative interest are subject to US withholding tax. For example the €1 in our example, might be treated as a withholdable payment from A in the United States to Germany. In 2015 the Securities Industry and Financial Markets Association ("SIFMA") wrote Treasury on exactly this topic. The IRS has yet to respond, at least in publicly available documents.

As negative interest rates spread throughout the globe, these and other tax issues will gain more scrutiny. If we get negative interest rates in the United States, CMTQ would expect the IRS to take notice and, hopefully, issue guidance. This time it is also likely that the negative interest rate environment will persist long enough so that some of the questions can be answered either by the IRS or by the courts. But, we've been wrong before about negative interest and only time will tell...

McKelvey Denied Cert

On June 17, 2019, the Supreme Court declined to grant certiorari in Estate of McKelvey v. Comm'r.3 The effect of the denial is that the Second Circuit decision in the government's favor will stand.

The taxpayer's petition to the Supreme Court argued that the Second Circuit effectively wrote regulations when it adopted a probability analysis in determining the meaning of "substantially fixed" under section 1259(d) of the Code.4 The taxpayer referred to this as "phantom regulation," since the circuit court interpreted a Code provision where Congress had directed the US Treasury to issue regulations, but Treasury had not done so.

Although the Supreme Court usually grants a writ of certiorari when there is a split in the circuits, the Supreme Court's denial leaves in place a present split between the circuits on the treatment of "phantom" regulation.5 Thus, only time will tell whether the Second Circuit decision will have broader significance for how courts treat situations in which they are asked to fill in regulatory gaps or if the decision will only be limited in application to the forward contracts and the Code provisions at issue in the case. At the very least, as we discussed in CMTQ Vol. 1 Issue 1 the questions raised by the Second Circuit's holding in McKelvey remain.

Proposed Financial Transactions Tax Favors Market Stability Over Liquidity6

On May 22, 2019, Presidential candidate Senator Bernie Sanders (I-VT) proposed the Inclusive Prosperity Act of 2019, which would impose a financial transactions tax (the "FTT") on trades of stocks, bonds and derivatives.7 The proposal imposes the FTT at different rates (a) 0.5% for stock transactions, (b) 0.1% for note, bond and debenture transactions, and (c) 0.005% for derivatives transactions. When debating the merits of an FTT, some experts assume the most realistic result is a flat rate of 0.1% applied to all transactions.8 This marks a sharp increase from the current fee rate for securities transactions of approximately 0.002% imposed under the US Securities and Exchange Commission (the "SEC") regulations9. Moreover, actual cost to investors may be higher than the proposed rate suggests. As written, the FTT would be assessed against a security's fair market value determined at time of sale.10

Sanders' new tax may disincentivize stock trading, and that appears to be the goal. Sanders has singled out high-frequency traders and other "greed[y]" and "reckless" investors as principal targets.11 According to critics, high-frequency trades destabilize financial markets and raise costs for "legitimate traders."12 Experts agree an FTT could reduce high-frequency trading; whether an FTT would also disincentivize investments based on market or company fundamentals is less certain. According to Kenneth E. Bentsen, Jr., president and CEO of SIFMA, average investors will be harmed.13 Bentsen stated that investors in 401(k) plans might face further complications, including double taxation. Moreover, an article from the Tax Policy Center suggests, at least in the short run, the tax would be passed along by the banks to investors.14 This could raise investment costs for vehicles like mutual funds, exchange-traded funds, and 401(k)s. Proponents of an FTT acknowledge the tax may impact larger sections of the economy, beyond high-frequency and Wall Street traders, although by how much is an open question.

While acknowledging these concerns, FTT proponents find principles of equity and stability dispositive. By targeting wealthy, high-frequency traders, the FTT is intended to produce "fairer and possibly less volatile" securities markets.15 One counter argument is that an FTT has the potential to decrease the quality, liquidity and size of American securities markets, particularly in New York.16

Sanders finds "considerable precedent" for his tax in the 40 or so countries which have imposed an FTT. The United Kingdom, Sweden, France and Italy all have imposed an FTT. All but one of these markets were subject to FTT rates above 0.5%. After implementing an FTT, some of these securities markets suffered negative effects, such as an increase in the cost of government pension plans, a decrease in the volume of stock-trade or a decrease in market liquidity.17

According to critics, including Bentsen at SIFMA, any reduction in liquidity will "unnecessarily raise costs for all investors" and threaten the prized status of America's securities market.18

If an FTT is put to a vote, the floor debate will likely revolve around this central policy question: whether the government should favor a liquid and efficient securities market or one which is less volatile and arguably more fair to "the average American family."19 Tax revenue projections may also be debated, although experts agree the returns may be lower than Sanders anticipates. Sanders estimates the tax would raise $2.4 trillion over ten years,20 while the Tax Policy Center estimated the 2016 version of Sanders' proposal (which was similar) would raise $400 billion over the same period.21

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1. S. Oh, "Value of Debt with Negative Yields hits $13 trillion," MarketWatch, June 21, 2019.

2. All section references are to the Internal Revenue Code of 1986, as amended.

3. For a refresher of the facts of the case and the holding of the Second Circuit, see Capital Markets Tax Quarterly Vol. 1, Issue 1, available at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2018/10/capital-markets-tax-quarterly/files/capital-markets-tax-quarterly-update_oct-2018_v7/fileattachment/capital-markets-tax-quarterly-update_oct-2018_v7.pdf

4. For a summary of the writ of certiorari filing, see Capital Markets Tax Quarterly Vol. 2, Issue 1, available at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2019/04/capitalmarketsquarterlynewsletter1904.pdf.

5. For a more detailed discussion of the split, see Stephanie Cummings, "Supreme Court Won't Touch Phantom Regs Issue" (June 18, 2019), available at https://www.taxnotes.com/tax-notes-today-federal/financial-instruments/supreme-court-wont-touch-phantom-regs-issue/2019/06/18/29mg7?highlight=mckelvey.

6. CMTQ would like to thank Mayer Brown summer associate, Max Fiest, for his assistance with this article

7. Inclusive Prosperity Act of 2019, S. 1579, 116th Cong. § 1 (2019), available at https://www.congress.gov/bill/116th-congress/senate-bill/1587/text.

8. See Klein infra fn 7 (discussing a flat rate FTT); Bentsen, Jr. infra fn 8 (same).

9. See Press Release – Fee Rate Advisory #2 for Fiscal Year 2019, available at www.sec.gov/news/press-release/2019-30?mod=article_inline.

10. The FTT would impose a tax equal to the "specified base amount" for each transaction. Inclusive Prosperity Act at 6. In the case of stock transactions, the tax would equal "the fair market value of the security (determined as of the time of the covered transaction)." Id. at 7.

11. See Inclusive Prosperity Act of 2019 Summary, available at https://www.sanders.senate.gov/download/inclusive-prosperity-act-of-2019-summary?id=8F81DAA3-84AF-435A-8B90-ECCEA61BC4D3&download=1&inline=file.

12. See Aaron Klein, Congress Wants to Tax Stock Trades; Investors Shouldn't Fret, Brookings (June 10, 2019), available at www.brookings.edu/opinions/congress-wants-to-tax-stock-trades-investors-shouldnt-fret/.

13. See Kenneth Bentsen Jr., The Facts Don't Support the FTT, SIFMA.org (June 13, 2019), available at www.sifma.org/resources/news/the-facts-dont-support-the-ftt/.

14. See Howard Gleckman, "Can the Sanders Financial Transaction Tax Raise Trillions And Cut Speculation?", available at www.taxpolicycenter.org/taxvox/can-sanders-financial-transactions-tax-raise-trillions-and-cut-speculation.

15. See Klein supra fn 7.

16. See Bentsen, Jr. (citing an analysis by the Joint Committee on Taxation).

17. See Bentsen, Jr. (citing an analysis by the Joint Committee on Taxation).

18. Id.

19. See Inclusive Prosperity Act of 2019 Summary supra fn 6.

20. See supra fn. 8.

21. See https://www.taxpolicycenter.org/taxvox/can-sanders-financial-transactions-tax-raise-trillions-and-cut-speculation. For reference, Sanders estimated his 2016 FTT proposal would raise $3 billion in ten years.

Originally published July 31 2019

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