21 January 2016 The Year in Review: Federal tax and legislative developments affecting asset managers in 2015 Asset managers continue to face an increasingly complex tax landscape given the multitude of reporting obligations and regulatory developments affecting the industry. 2015 was no exception. Staying apprised of these developments is vital to minimizing exposures for fund investors, as well as their principals. The following is a summary of select developments that occurred in 2015 affecting asset managers both in 2015 and beyond. President signs legislation repealing TEFRA partnership provisions and replacing with new partnership audit and litigation provisions On November 2, 2015, the President signed the Bipartisan Budget Act of 2015 (the Act), which includes revenue provisions that install a new audit system for most partnerships, effective for tax years beginning after December 31, 2017. The Act replaces the existing TEFRA and ELP procedures for all partnerships with 100 or more partners and any other partnership with a flow-through partner (including a disregarded entity). For further discussion, see Tax Alert 2015-2085. The provisions of the Act will have significant implications to hedge funds given their investor make-up and partnership tax status. Although many hedge funds may have less than 100 partners, most hedge funds have at least one partner that is also a partnership (i.e., typical master-feeder structure), rendering most, if not all, ineligible to elect out of the new regime. Consequently, hedge funds will either be subject to the provisions of the default rule, or have the option to elect to be subject to the alternative method for imputed underpayments. There is a considerable amount of guidance the IRS and Treasury will need to provide taxpayers on the application of these new provisions. Undoubtedly though, we expect these revised procedures to make audits of large partnerships, including hedge funds, more streamlined for the IRS, potentially causing an increase in the number of audits that the IRS can perform in a given year. It would be prudent for fund managers to revisit their record-keeping and documentation processes to ensure all tax positions have adequate support in the case of an audit. An assessment should also be made regarding financial statement reporting implications of the new rules and the elections thereunder. Fund managers should be aware of the options under these new rules and understand the effect of the alternatives based on each partnership's particular facts and circumstances. Future structuring considerations should be reviewed now to maximize the number of partnerships that would be eligible to elect out of the default rule. In T.D. 9734 and REG-127895-14, the IRS issued the long-awaited final regulations under Section 871(m), which govern withholding on certain notional principal contracts (NPCs), derivatives and other "equity-linked instruments" (ELIs) with payments that reference (or are deemed to reference) dividends on US equity securities. These regulations impose US withholding tax on certain amounts arising in derivative transactions over US equities when those amounts are paid to a non-US person. The final regulations generally adopt the proposed regulations issued in 2013, with some (generally pro-taxpayer) changes. This Treasury decision also included temporary (and proposed) regulations that provided new rules for determining whether certain complex derivatives are subject to Section 871(m) and for payments by certain dealers. For additional information, see Tax Alert 2015-1819. By raising the "delta" threshold for determining whether a derivative is in scope and providing that testing is only required at initial issuance, the changes made by the final regulations greatly reduce the likelihood that US withholding tax will be imposed on options and convertible bonds. "Delta" refers to a ratio widely used in the derivatives market to measure risk; it broadly measures the change in the value of a derivative relative to the change in the value of the underlying referenced property in the derivative. There is a rule in the final regulations that could treat multiple transactions as a single transaction for purposes of the delta test if the transactions are entered into "in connection with" each other. The regulations further provide certain presumptions as to when transactions would not be considered to have been entered into in connection with each other. While long parties cannot rely on these presumptions, their existence will as a practical matter reduce the likelihood that dealers will withhold on derivative contracts. In general, the new regulations apply to NPCs and ELIs entered into on or after January 1, 2017, and the old rules (as laid out in Section 871(m)) that began in 2012 continue to apply to NPCs that reference US equity securities for contracts entered into before 2017. The new regulations as originally issued could have applied to certain NPCs or ELIs entered into during 2016 that remained outstanding after 2017, but this provision subsequently was withdrawn. For further discussion of the change in applicability date, see Tax Alert 2015-2295. Relief provided by IRS through clarifications and definitions regarding newly designated listed transaction and transaction of interest On October 21, 2015, the IRS issued Notice 2015-73, designating a new listed transaction, "Basket Option Contracts," and Notice 2015-74, designating a new transaction of interest, "Basket Contract," (new notices) and revoking Notices 2015-47 and 2015-48 (original notices) respectively. The transactions involve financial instruments that were intended to produce character and timing benefits for taxpayers. The new notices clarify the descriptions of the types of transactions that constitute a listed transaction and transaction of interest (TOI) that must be disclosed by taxpayers under Treas. Reg. Section 1.6011-4 and by material advisors under Treas. Reg. Section 301.6111-3(a). For additional information, see Tax Alert 2015-2084. The clarifications provided in the new notices more closely align the reporting implications to those transactions providing the opportunity to alter the character and timing of income for taxpayers. Notably, the new notices omit broad language contained in the original notices that would have brought into the definition of a TOI those contracts that arguably avoid withholding and reporting obligations, which could have had disclosure implications to many types of derivatives. Furthermore, the transactions are restricted to those where the taxpayer or designee reflects a deferral of income or conversion of character, which better aligns the reporting between the two parties, creating less instances of unnecessary and contradictory reporting. Additionally, many common capital markets transactions were explicitly excluded. Asset managers should consider the potential implications of any swap, option, futures, or other derivative contracts that might be implicated by these new notices and communicate where necessary with counterparties to ensure necessary reporting is completed timely to avoid any penalty implications. On March 2, 2015, the taxpayer in Sands v. Commissioner petitioned the Tax Court to redetermine a deficiency asserted by the IRS with respect to self-employment taxes on income flowing from a limited partner interest in a limited partnership. Under Section 1402(a)(13), a limited partner's share of partnership income is generally not subject to self-employment tax. While Sands v. Commissioner involved a limited partnership and not an LLP or LLC, the previous assertions of self-employment tax liability in the case of Renkemeyer, et al v. Commissioner, 136 T.C. 137 (2011), as well as in prior Chief Counsel Advice, focused on LLC members raising the question of whether the IRS was seeking to narrow the Section 1402(a)(13) exception to self-employment tax. In a stipulated decision issued May 29, 2015, however, the IRS agreed there was no self-employment tax deficiency under the facts presented in Sands v. Commissioner. While this was a welcome development, it is unclear how broad an application there is to the resolution of this case. In Revenue Procedure 2015-14, the IRS updated and expanded the list of eligible automatic accounting method changes, along with the specific terms and conditions for each change. While previous guidance allowed automatic changes for securities traders and commodities traders to elect to use mark-to-market accounting under Section 475, no automatic changes to revoke such an election were previously permitted. Revenue Procedure 2015-14 added an automatic method change for taxpayers wishing to move away from the Section 475 mark-to-market method and adopt a realization method of accounting. This is a welcome opportunity for hedge fund managers interested in revoking their Section 475 election for tax year 2016 and beyond as it allows for a more streamlined administrative mechanism to do so, although the timing is more constrained than with a nonautomatic change, which is no longer allowed. Determination of invalid mark-to-market election provides hedge fund managers additional insight into trader vs. investor analysis In William F. Poppe v. Commissioner (T.C. Memo. 2015-205), the Tax Court held that the taxpayer did not fulfill the necessary filing requirements to make a valid Section 475(f)(1) mark-to-market election. Distinct from other recent cases, the court held that, although the petitioner was a trader in stocks and securities, a prerequisite to making the election was not satisfied. This prerequisite is the procedural requirement of filing Form 3115, Application for Change in Accounting Method. Therefore, the court held that the petitioner did not have a valid election and may not use the mark-to-market method (and get ordinary character) for losses. For further discussion, see Tax Alert 2015-2066. The classification of a fund as either trader or investor continues to be a topic of interest for hedge fund managers, as the implications to that classification extend beyond those at issue in this case. Most significantly, "trader" status enables a fund to take most of its expenses as "above-the-line" trade or business expenses and not as "portfolio" deductions subject to limitations on deductibility. With regard to the trader/investor classification, the decision in Poppe appears to shed new light on a couple of aspects of the definition of securities trader that are taxpayer-favorable. The court cited, with approval, an average holding period of almost one month, somewhat undercutting statements it had made in prior memorandum decisions that seemed to imply day trading as the new standard for how a trader is defined. For example, this is seemingly in contrast to the decision in Endicott v. Commissioner (see Tax Alert 2013-1785). Therefore, it bears watching how the court views these issues moving forward. Although Tax Court memorandum decisions are not precedential, given the lack of other recent guidance regarding how a trader is defined, the dicta in this decision can be viewed as helpful in that it appears to move away from a day-trader requirement. On December 18, 2015, the president signed into law the "Protecting Americans from Tax Hikes Act of 2015," funding the government through fiscal year 2016 and addressing expired tax extenders. The legislation makes several tax provisions permanent, and extends others anywhere from two to five years, and made some additional changes to existing law; some of which may have significant impact to hedge fund managers. The provisions extend bonus depreciation for property acquired and placed in service during 2015 through 2019. The bonus depreciation percentage will be 50%for property placed in service during tax years 2015 through 2017 and phases down in 2018 and 2019 to 40% and 30% respectively. The provision allows taxpayers to accelerate the use of AMT credits in lieu of bonus depreciation under special rules for property placed in service during 2015, but in 2016 modifies the AMT rules by increasing the amount of unused AMT credits that may be claimed in lieu of bonus depreciation. The provision also modifies bonus depreciation to include qualified improvement property. Section 179 expensing limitations are now permanently extended, increasing the expensing limitation and phase out amounts to $500,000 and $2 million, respectively (increased from $25,000 and $200,000, respectively). The special rules that allow expensing for computer software and qualified real property are also permanently extended. In general, under the "FIRPTA" rules of Section 897, gains on the sale of stock of US corporations, including certain REITs, that predominantly own US real estate are deemed to be income effectively connected with the conduct of a US trade or business. Thus, foreign investors are subject to US tax on such gains, and must file tax returns in order to pay the tax. Similar rules apply to capital gain dividends paid by REITs that predominantly own US real estate.1 Under prior law, there was an exception for "portfolio" investors. Gains on the sale of an interest in a publicly-traded class of stock of a US corporation that predominantly owned US real estate were exempt, provided that the investor had never held more than 5% of that class of stock during the prior five years.2 A similar rule applied to capital gain dividends paid with respect to a publicly-traded class of REIT shares, provided that the investor had never held more than 5% of that class during the prior year. (Instead, such capital gain dividends derived by such a non-US investor were treated as "ordinary" dividends subject to tax at 30% or lower applicable treaty rate.)3 In the case of gains on sale and capital gain dividends derived by partnerships, there was no definitive guidance that allowed one to look through the partnership and apply the 5% test at the partner level. The Act makes two changes to the FIRPTA portfolio investor exemption. First, the ownership threshold is increased from 5% to 10% for stock of publicly traded REITs (but not for other publicly traded US corporations that own predominantly US real estate).4 Second, in the case of ownership through a foreign partnership, the ownership threshold test applies at the partnership level, but in some limited circumstances, it may be possible to apply the ownership threshold test at the partner level.5 The three-month highway funding extension President Obama signed into law July 31, 2015, modifies the filing dates for tax returns commonly filed by asset managers. General changes to due dates and extension periods affect a number of forms, including, but not limited to, corporate, partnership, and estate and trust income tax returns (Forms 1120, 1120S, 1065 and 1041) as well as FinCEN Report 114 (relating to Report of Foreign Bank and Financial Accounts). For additional information, see Tax Alert 2015-1544. In general, the changes affect returns for tax years 2016 and after. Although the original filing dates for partnerships and corporations will change, the extended due dates should remain the same, (i.e., September 15 for calendar year partnerships and corporate entities). With the majority of hedge funds typically extending their tax return filings, most changes to the due dates do not create a significant compliance impact to fund managers. State and local jurisdictions will likely assess how their respective income tax filing dates may change as a result of these federal changes. Treasury grants yet another extension of time for reporting signature authority (FBAR, Form 114) over certain foreign financial accounts On December 8, 2015, the Financial Crimes Enforcement Network (FinCEN) issued FinCEN Notice 2015-1, granting yet another extension of time for certain persons to file a Report of Foreign Bank and Financial Accounts (FBAR) with respect to signature authority over foreign financial accounts. This Notice is only relevant for reports of: (i) certain officers and employees of publicly traded or widely held companies with signature authority over foreign financial accounts held by group members and (ii) employees of SEC-registered investment advisors with signature authority over foreign financial accounts owned by customers that are not regulated investment companies, such as hedge funds. Before issuance of this current Notice, these persons had been given an extension of time to file regarding signature authority for 2014 and prior years until June 30, 2016. This Notice (2015-1) grants them a further extension of time to file regarding signature authority for 2015 and prior years until April 15, 2017. Note that neither Notice 2015-1 nor its predecessor guidance provides additional time to report financial interests in foreign financial accounts. Nor do they provide additional time to report signature authority over accounts owned by either closely held groups that are not financial institutions or foreign-listed publicly traded groups. They also provide no relief for signature authority over customer accounts held by third parties other than employees of registered investment advisors. The deadline for filing Form 114 for individuals with signature authority over an account during calendar year 2015 who did not benefit from the extensions provided by Notices 2011-1 and 2011-2 as previously extended, is not affected by Notice 2015-1 and remains June 30, 2016. See Tax Alert 2015-2345. On November 24, 2015, the IRS released Notice 2015-82 (the Notice), providing an increased threshold for expense deductions as part of the tangible property regulations that were finalized last year (see Tax Alerts 2013-1752 and 2014-1466). The amount has increased from $500 to $2,500 and applies to taxpayers without an applicable financial statement (AFS) (audited financial statement). For taxpayers with an applicable financial statement, the de minimis threshold remains $5,000. Under the de minimis safe harbor election, eligible taxpayers may elect not to capitalize certain amounts paid for the acquisition or production of tangible property or treat that amount as a material and supply if they make an annual election. The safe harbor applies only if the amount paid meets certain requirements. Under the final Tangible Property Regulations, taxpayers without an AFS generally may elect to apply the de minimis safe harbor to property expensed for book purposes as long as the property does not exceed $500 per invoice (or per item as substantiated by the invoice) or other amounts identified in published guidance in the Federal Register or the Internal Revenue Bulletin. As this Notice will be published in the Internal Revenue Bulletin, taxpayers without an AFS may rely on the guidance while applying the de minimis safe harbor. The Notice provides asset managers additional relief to expense more items for tax year 2015 than originally planned. The new threshold allows for immediate deduction of expenses that would otherwise need to be capitalized and depreciated over the applicable useful life. This additional relief could be of value to many taxpayers. See Tax Alert 2015-2279. The IRS issued final, temporary (TD 9719) and proposed (REG-102656-15) regulations (the 2015 regulations) that eliminate in many cases the requirement to treat nonperiodic payments made with respect to notional principal contracts (NPCs) as one or more loans and in all remaining cases require loan treatment regardless of whether the nonperiodic payment is significant. The 2015 regulations also provide an exception from Section 956 for certain related-party NPCs that might otherwise be treated as an investment in United States property. For further discussion, see Tax Alert 2015-924. The 2015 regulations greatly simplify the issue of whether an NPC has an embedded loan by generally treating any NPC with a nonperiodic payment as resulting in a loan, regardless of the size of the nonperiodic payment. Swaps with only upfront nonperiodic payments, however, should qualify for one of the exceptions, assuming they are either short-term or are cleared through a clearinghouse. The requirements for the exceptions are specific and taxpayers should assess whether the terms of their particular NPC satisfy the requirements for either of the exceptions. For example, over-the-counter swaps may not qualify for the full margin exception if margin or collateral is not required on a daily basis or if the parties are not required to collect the margin or collateral. The posting of Treasuries, which used to be a common practice in over-the-counter swaps, appears not to qualify for the full margin exception. In addition, it is not clear whether or how the rules apply to caps and floors or to NPCs with contingent nonperiodic payments. Finally, taxpayers with CFCs entering into NPC contracts with related parties should analyze whether these CFCs qualify as dealers (among other requirements) in order to qualify for the exception to US property treatment. On July 22, 2015, the IRS released proposed regulations (REG-115452-14) under Section 707(a)(2)(A) that recharacterize certain allocation and distribution arrangements as disguised payments for services. The proposed regulations are effective on the date final regulations are published, and any arrangement entered or modified after the effective date would be governed by the final regulations. The IRS has stated, however, that it believes that the proposed regulations generally reflect Congressional intent, indicating that the IRS may argue for the application of the principles articulated in the proposed regulations, even before they are finalized. For additional information, see Tax Alert 2015-1450. The IRS issued the proposed regulations in response to its expressed concerns with certain management fee waivers (MFWs). Accordingly, the proposed regulations should be considered in the structuring of new MFWs and also considered when fee waivers are exercised under pre-existing MFW provisions. Alternative asset managers, especially private equity fund managers, often employ an MFW whereby the sponsor surrenders all, or some, of its management fee in exchange for an increased share of a fund's profits or carried interest. The proposed regulations would, if finalized in their present form, change the US federal income tax consequences of a management fee waiver in which the manager's recovery of its waived fee was not subject to significant entrepreneurial risk. 2015 was a busy year for tax legislation and guidance. Many of these developments provided some level of relief, while others created new considerations and complications for hedge fund managers. Now is a good time to review these developments with your tax advisor and understand their implications to your business and your investors.
Document ID: 2016-0152 | |||||||||
