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Tax Insights, September 23, 2015
Tracking Tax News You Need to Know

September 23, 2015
Publications
IRS Issues Final Dividend Equivalent Payment Regulations Under Section 871(m)
The IRS issued final regulations, generally adopting 2013 proposed regulations, on the treatment of “dividend equivalents” as dividends from sources within the U.S. for various U.S. income tax purposes (including the application of withholding tax). The IRS also issued temporary regulations on related subjects, including whether certain complex derivatives are dividend equivalents. The text of the temporary regulations serves as the text of proposed regulations.

Some highlights of the final regulations are as follows:
  • Definition of Specified NPC. The regulations amend final regulations issued in 2013 by extending the application of the temporary definition of specified notional principal contract (NPC) adopted in the 2013 final regulations to payments made before Jan. 1, 2017. An NPC that is treated as a specified NPC pursuant to Treasury Regulation Section 1.871-15(d)(1)(i) will remain a specified NPC on or after Jan. 1, 2017. Under the 2013 final regulations, a specified NPC is one where (a) the long party transferred the underlying security to the short party in connection with entering into the NPC, (b) the short party transferred the underlying security to the long party in connection with the termination of the NPC, (c) the underlying security is not readily tradable on an established securities market, or (d) the short party posted the underlying security as collateral with the long party.
  • Delta Testing. In determining whether a transaction is a specified NPC or a specified equity-linked instrument (ELI), the 2013 proposed regulations provided a “delta”-based standard under which, with respect to payments made on or after Jan. 16, 2016, any NPC or ELI that has a delta of 0.70 or greater when the long party acquires the transaction is a specified NPC or specified ELI, respectively. The delta test in the final regulations applies only to “simple contracts” (defined below).

    The delta of an NPC or an ELI was the ratio of the change in the fair market value (FMV) of the NPC or ELI to the change in the FMV of the referenced property, determined in a commercially reasonable manner.

    The final regulations make a number of changes to the delta test, including:

(a) adopting a delta threshold of 0.80 instead of 0.70;

(b) changing the definition of delta to be the ratio of the change in the FMV of an NPC or ELI to a small change in the FMV of the number of shares of the underlying security referenced by the NPC or ELI (typically, a small change is a change of less than 1 percent);

(c) providing that the delta of a potential Section 871(m) (section references are to the Internal Revenue Code of 1986, as amended) transaction is determined only when the potential Section 871(m) transaction is issued (it is not retested when, for example, the instrument is purchased or acquired in a secondary market); (d) providing that if a short party issues a contract that references a basket of 10 or more underlying securities and uses an exchange-traded security, such as an exchange-traded fund, that references substantially the same underlying securities to hedge the contract at the time it is issued, the short party may use the hedge security to determine the delta of the security it is issuing rather than determining the delta of each security referenced in the basket; and

(e) eliminating the “constant delta” rule.
  • Simple and Complex Contracts. The final regulations acknowledge that, in some cases, the delta is indeterminate because the number of shares of the underlying security that determine the payout of the derivative cannot be known at the time the contract is entered into. The IRS concluded that an alternative to the delta test is needed for contracts with indeterminate deltas.

    To address these contracts, the final regulations distinguish between “simple contracts” and “complex contracts.” Generally, a simple contract is a contract that references a single, fixed number of shares of one or more issuers to determine the payout. The number of shares must be known when the contract is issued. In addition, the contract must have a single maturity or exercise date on which all amounts (other than any upfront payment or any periodic payments) are required to be calculated with respect to the underlying security.

    A complex contract is any contract that is not a simple contract. Contracts with indeterminate deltas are classified as complex contracts, which are subject to a new substantial equivalence test set forth in the temporary regulations.

    To test whether a complex contract is a Section 871(m) transaction, the temporary regulations adopt a “substantial equivalence” test. Generally, the substantial equivalence test measures the change in value of a complex contract when the price of the underlying security referenced by that contract is hypothetically increased by one standard deviation or decreased by one standard deviation (each, a “testing price”), and it compares that change with the change in value of the shares of the underlying security that would be held to hedge the complex contract.
  • Timing for Withholding. The final regulations provide that a withholding agent is not obligated to withhold on a dividend equivalent until the later of when a payment is made with respect to a Section 871(m) transaction or when the amount of a dividend equivalent is determined. A payment with respect to a Section 871(m) transaction generally occurs when the long party receives or makes a payment, when there is a final settlement of the Section 871(m) transaction, or when the long party sells or otherwise disposes of the Section 871(m) transaction. For options and other contracts that typically require an upfront payment, the final regulations do not treat the premium or other upfront payment as a payment for withholding purposes.
  • Insurance Contracts. The temporary regulations state that there is no dividend equivalent associated with a payment that a foreign person receives pursuant to the terms of an annuity, an endowment, or a life insurance contract issued by a domestic insurance company (including the foreign or U.S. possession branch of the domestic insurance company).
  • Effective Date. The final and temporary regulations generally are effective on Sept. 18, 2015. In addition, with respect to Section 871(m) transactions issued on or after Jan. 1, 2016, and before Jan. 1, 2017, the regulations also apply to any payment of a dividend equivalent made on or after Jan. 1, 2018.

    The preamble to the regulations notes that previously issued chapter 4 (FATCA) regulations provide a coordinating effective date for the treatment of dividend equivalents as withholdable payments for purposes of FATCA withholding. Treasury Regulation Section 1.1471-2(b)(2)(i)(A)(2) provides that grandfathered obligations under FATCA include any obligation that gives rise to a withholdable payment solely because the obligation gives rise to a dividend equivalent pursuant to Section 871(m) and the regulations thereunder. The grandfather rule applies only to obligations that are executed on or before the date that is six months after the date on which obligations of its type are first treated as giving rise to dividend equivalents.
IRS Issues Final Regulations on Controlled Group Rules for RICs
The IRS issued final regulations (TD 9737) clarifying how the controlled group rules apply for purposes of the regulated investment company (RIC) asset diversification test. The final regulations generally adopt the provisions of the proposed regulations.

The final regulations clarify that as few as two corporations are enough to constitute a controlled group if the ownership requirements of Section 851(c)(3) are satisfied, i.e., (i) 20 percent or more of the total combined voting power of all classes of stock entitled to vote from each of the corporations (excluding the taxpayer) is owned directly by one or more of the other corporations, and (ii) the taxpayer owns directly at least 20 percent or more of the total combined voting power of all classes of stock entitled to vote from at least one of the other corporations.

Commenters stated that there might be uncertainty in determining whether an upper-tier RIC satisfies its 25 percent tests when what might otherwise be a quarter-end violation by the lower-tier RIC is saved from being a violation by one or both of the relief provisions (the “market value exception” and the “30-day-cure provision”), or when the upper-tier RIC and a lower-tier RIC have different quarter-end testing dates. Commenters also noted that securities of RICs are listed as qualifying assets for purposes of the “good asset” 50 percent test under Section 851(b)(3)(A) and also are excluded from the categories of assets listed in the 25 percent tests under Sections 851(b)(3)(B)(i) and 851(b)(3)(B)(ii). Rather than resolve this uncertainty in the regulations, the IRS issued Revenue Procedure 2015-45, 2015-39 IRB, discussed below.

Comments also were received stating that an interest in a qualified publicly traded partnership (QPTP) should not be subject to the clarified controlled group rules under the regulations when the interest in the QPTP is held by a corporation that is not a RIC. Commenters suggested that the Section 851(b)(3)(B)(iii) QPTP test (which focuses on a RIC’s holdings of securities of a category of issuers) is different from the Sections 851(b)(3)(B)(i) and 851(b)(3)(B)(ii) tests (focusing on a RIC’s holdings of securities of particular issuers). Some RICs have taken the position that they can invest 25 percent of their assets in a QPTP directly and then invest an additional 25 percent indirectly through a wholly owned subsidiary. The final regulations are designed to prevent that second indirect investment.

Generally, the final regulations apply to quarters that begin on or after Dec. 14, 2015.

IRS Issues Revenue Procedure on Fund of Funds and 25 Percent Asset Diversification Test
The IRS issued Revenue Procedure 2015-45 establishing a safe harbor that allows a RIC that invests in one or more other RICs to satisfy the 25 percent asset diversification test set forth in Section 851(b)(3)(B). If an upper-tier RIC holds 20 percent or more of the total combined voting power of all classes of stock entitled to vote of a lower-tier RIC or RICs within the meaning of Section 851(c)(3), the upper-tier RIC and the lower-tier RIC or RICs constitute a chain of corporations connected through stock ownership and are members of a controlled group. Therefore, Section 851(c)(1) and Treasury Regulation 1.851-3 require the upper-tier RIC to include its proportionate share of the assets of the lower-tier RIC or RICs in determining whether the upper-tier RIC satisfies the 25 percent tests at the end of each of its quarters.

Under the revenue procedure, an upper-tier RIC will be treated as satisfying the 25 percent test for a quarter provided that:

(a) the upper-tier RIC invests solely in cash, cash items, government securities, and securities of one or more lower-tier RICs, and each lower-tier RIC that is a member of the upper-tier RIC’s controlled group, taking into account the market value exception and 30-day-cure provision of Section 851(d)(1), is treated as satisfying the 25 percent test for each quarter that ends during or concurrently with the quarter of the upper-tier RIC; or

(b) the upper-tier RIC invests in cash, cash items, government securities, securities of one or more lower-tier RICs, and other stocks and securities, and (i) each lower-tier RIC that is a member of the upper-tier RIC’s controlled group, taking into account the market value exception and 30-day-cure provision of Section 851(d)(1), satisfies the 25 percent test for each quarter that ends during or concurrently with the quarter of the upper-tier RIC; and (ii) disregarding the upper-tier RIC’s investments in the securities in each lower-tier RIC that is a member of the upper-tier RIC’s controlled group and the upper-tier RIC’s proportionate share of any securities held by those lower-tier RICs, the upper-tier RIC satisfies the 25 percent test with respect to the remainder of its assets.

In determining whether a RIC within a chain of corporations satisfies the requirements of the revenue procedure, the 25 percent test (taking into account the market value exception and 30-day-cure provision) is applied (a) first, to a lower-tier RIC that is not also an upper-tier RIC in the chain; (b) next, successively up the chain to each other lower-tier RIC in the chain; and (c) last, to the upper-tier RIC that is not also a lower-tier RIC.

The revenue procedure is effective for quarters ending after Sept. 14, 2015.

IRS Issues Notice Describing Areas of Concern Under Section 355 and Issues Revenue Procedure Expanding No-rule Areas; RICs and REITs Implicated in Guidance
In Notice 2015-59, the IRS announced that it is studying issues relating to the tax-free qualification of spinoffs with one or more of the following characteristics: (a) ownership by the distributing corporation or controlled corporation of a substantial amount of “investment assets” (e.g., cash, stock, securities and similar assets) when compared with its total assets or the assets that it relies on to satisfy the “five-year active trade or business” requirement of the tax-free spinoff rules (“business assets”); (b) a significant difference between the distributing corporation’s ratio of investment assets to noninvestment assets and such ratio of controlled corporation; (c) ownership by the distributing or controlled corporation of a small amount of business assets compared with its total assets; and (d) election by the distributing or controlled corporation (but not both) to be a REIT or a RIC. The IRS is concerned that such spinoffs might skirt existing rules (e.g., business purpose, the active trade or business requirement, the device limitation, etc.) intended to impose corporate-level tax when a corporation distributes built-in gain assets to its shareholders.

The IRS released Revenue Procedure 2015-43 concurrent with the release of Notice 2015-59. In the revenue procedure, the IRS indicates that it ordinarily will not provide private letter rulings on Section 355 transactions that have any of the following characteristics: (a) the fair market value of the gross assets of the active trade or business is less than 5 percent of the total fair market value of the gross assets of the distributing or controlled corporation, or (b) either the distributing or the controlled corporation, but not both, becomes either a REIT or an RIC. Further, the IRS indicates that it temporarily will not provide private letter rulings on Section 355 transactions in which the fair market value of the investment assets constitute two-thirds or more of the total fair market value of gross assets of the distributing or controlled corporation. Revenue Procedure 2015-43 does not prohibit taxpayers from engaging in spinoff transactions under the circumstances described, but likely increases the level of uncertainty involving such transactions.

IRS Issues Two Rulings on Qualifying Income of PTPs
The IRS released two private letter rulings on qualifying income earned by a publicly traded partnership (PTP). In PLR 201537007, the IRS rules that income derived by a PTP directly or indirectly from contracts for processing, regasification, liquefaction, and storage of natural gas constitutes qualifying income under Section 7704(d)(1)(E). In another ruling (PLR 201537014), the IRS rules that income derived by a PTP from gathering, transporting, processing, treating, and disposing of saltwater produced in exploration and production of oil and natural gas, and from recovery and marketing of skim oil other than to end users at retail level, constitutes qualifying income under Section 7704(d)(1)(E).

IRS Issues Proposed Regulations on Tax Treatment of Outbound Transfers of Intangibles
The IRS issued proposed regulations on certain transfers of property by U.S. persons to foreign corporations in nonrecognition transactions under Section 367. Section 367(d)(1) provides that if a U.S. transferor transfers any intangible property (e.g., patents, copyrights, trademarks, etc.) to a foreign corporation in an exchange described in Sections 351 or 361, the U.S. transferor is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of the property and as having received amounts that reasonably reflect what would have been received annually in the form of such payments over the shorter of the property’s useful life or 20 years, or in the case of a disposition of the intangible property following such transfer, at the time of the disposition. However, under the “foreign goodwill exception,” the transfer of foreign goodwill or going concern value is excepted from the disposition rule. The IRS is aware that certain taxpayers, in the context of outbound transfers, attempt to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share of the value of the property transferred is foreign goodwill or going concern value eligible for favorable treatment under Section 367, and to do so, taxpayers are valuing the property transferred in a manner contrary to the transfer pricing rules of Section 482.

The proposed regulations would eliminate the foreign goodwill exception and limit the scope of property that is eligible for the active trade or business exception to certain tangible property and financial assets. This would subject more transfers to current gain recognition under Section 367(a)(1) or the deemed distribution rule for intangibles under Section 367(d). Under the proposed regulations, transfers of property by a U.S. person to a foreign corporation would be subject to tax whether or not used in an active trade or business. The “active trade or business” exception would apply only to specified “eligible property” that is transferred for use in an active trade or business and with respect to which certain reporting requirements are met. Eligible property would include tangible property; a working interest in oil and gas property; and certain specified financial assets, including “securities,” which are broadly defined but exclude, for example, a partnership interest, certain commodities positions, a notional principal contract, and cash. The proposed regulations generally would apply to transfers occurring on or after Sept. 14, 2015, as well as to transfers occurring before that date resulting from entity classification elections under Treasury Regulation Section 301.7701-3 that are filed on or after Sept. 14, 2015. The IRS contemporaneously issued temporary regulations under Section 482 to clarify the coordination of the transfer pricing rules with other sections of the Internal Revenue Code, including Section 367.

IRS Issues Temporary Regulations Coordinating Section 482’s Arm’s-length Standard and Best Method Rule
The IRS issued temporary regulations clarifying the coordination of the arm’s-length standard and the best method rule under Section 482 with other provisions of the Internal Revenue Code, effective for tax years ending on or after Sept. 14, 2015. The text of the temporary regulations also serves, in part, as the text of contemporaneously issued proposed regulations.

IRS Releases Revenue Procedure Providing Guidance on Depreciation Changes Under TIPA
The IRS released Revenue Procedure 2015-48, which provides guidance on changes made by the Tax Increase Prevention Act of 2014 to provisions dealing with Section 168(k) bonus depreciation, the Section 168(k)(4) election to forego bonus depreciation and increase the alternative minimum tax credit, and the Section 179 expensing election for real property.

IRS Releases Notice on Application of Jeopardizing Investment Tax to Non-program-related Investments
The IRS released Notice 2015-62, 2015-39 IRB, providing guidance on the application of the jeopardizing investment excise tax under Section 4944 to investments that are made by private foundations for charitable purposes described in Section 170(c)(2)(B) but that do not meet the other requirements to qualify as program-related investments (PRIs) excepted from treatment as jeopardizing investments subject to the tax. The notice does not express an opinion on whether the excise tax would apply. The notice instead states that liability for the tax is based on whether the foundation managers exercised appropriate business care and prudence in making the investment, thereby implying that a non-PRI might not be subject to the tax, provided that standard was satisfied.

IRS Issues Proposed Regulations on Contemporaneous Charitable Contribution Acknowledgement
The IRS issued proposed regulations that would require donees who opt to use donee reporting to report the information described in Section 170(f)(8)(B), as well as the donor’s name, address and taxpayer identification number. The donee reporting information would be sent to both the IRS and the donor. If a contribution is not reported using donee reporting, then the donor must obtain a contemporaneous written acknowledgment from the charity. The IRS requests comments on the proposed regulations.

Section 170(f)(8)(B) requires a donee organization to provide the following information in a contemporaneous charitable contribution acknowledgment for any contribution of $250 or more: (a) the amount of cash and a description of any property other than cash contributed; (b) whether any goods and services were provided by the donee organization in consideration for the contribution; and (c) a description and good-faith estimate of the value of any goods and services provided by the donee organization, or a statement that such goods and services consist solely of intangible religious benefits. Section 170(f)(8)(D) provides an exception under which a contemporaneous written acknowledgment is not required if the donee organization files a return, on such form and in accordance with such regulations as the IRS prescribes, that includes the information described in Section 170(f)(8)(B).

The IRS’s long-standing position is that the Form 990 series should not be used for donee reporting. Instead, before finalizing the proposed regulations described above, the IRS intends to develop a specific-use information return for donee reporting. Donees would not be required to adopt donee reporting, but donees who choose to use donee reporting would be required to provide a copy of the information return to the donor at the address the donor provides for this purpose, and the information return would contain only the information related to that donor.

Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

Copyright © 2015 Stradley Ronon Stevens & Young, LLP. All rights reserved.

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