Asset managers have many issues to consider from the past year, from the election results in November to various other developments that may impose large-scale operational changes across the industry. Regulators continue to have a high level of focus on asset management. It is important to be aware of how recent law changes could affect your business. The following is a summary of select developments affecting asset managers that occurred in 2016.

Section 871(m) application and enforcement reduced in scope for 2017

In September 2015, the IRS issued final regulations on an expanded regime providing rules for withholding on "dividend equivalent payments" to non-US persons for derivatives referencing dividend-paying US equity securities (Section 871(m)). These regulations significantly affect asset managers whose investment portfolios include notional principal contracts and other instruments linked to US equities. The regulations generally apply to notional principal contracts (NPCs) and equity-linked instruments (ELIs) entered on or after January 1, 2017, with a delta of 0.8 or higher.

On December 2, 2016, the IRS released much anticipated guidance in Notice 2016-76, which provides, among other items, a phase-in of the expanded Section 871(m) rules over two years. Generally, for 2017, only delta-one products (such as total returns swaps, futures and forwards) will be subject to withholding. All other applicable products will become subject to withholding in 2018. This generally responds to numerous comments from the industry voicing concerns over the challenges of complying with some aspects of the rules and implementing new systems that will be needed. For additional information, see Tax Alert 2016-2084.

The Notice states that, for 2017 and 2018, the IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the regulations. It also provides for a simplified standard for the short party in determining whether transactions are combined transactions. The long party (typically the fund), however, is not able to apply the simplified standard and must assess in 2017 the extent to which it employs strategies with multiple transactions that collectively achieve a delta of one (e.g., creating a synthetic forward by combining a long call with a short put).

Substantial changes were also made regarding a Qualified Derivatives Dealer (QDD). Payments to a QDD are generally exempt from Section 871(m) withholding if the QDD has provided proper documentation to its counterparty. The QDD itself, however, generally has a withholding tax liability on in-scope positions. Asset managers should make sure that all their counterparties have, or are in the process of obtaining, QDD status so no withholding will be required when the fund is the short party in a transaction.

Despite the limited relief, we recommend that asset managers continue to refine their processes and prepare for the full application of these rules in 2018. This will include documenting the actions taken, issues encountered and efforts made to implement the Section 871(m) regulations. Managers should also understand how the Section 871(m) tax liability will affect net asset value (NAV) calculations, monitor transactions related to strategies subject to the combination rule or qualified index exception and consider the need to update existing service-level agreements.

Further challenges exist for fund of fund (FOF) managers, as an FOF may not receive information sufficient to satisfy its obligation to withhold on dividend equivalents allocated to its non-US investors, or to perform accurate NAV calculations. FOF managers should be proactive in communicating with underlying funds to ensure that they receive required information.

Update on new partnership audit procedures

Partnership audit rules were enacted by the Bipartisan Budget Act of 2015 (Budget Act), effective for tax years beginning after December 31, 2017. The rules repeal TEFRA and ELP procedures and require audits to now be conducted at the partnership level and any tax liability to be paid by the partnership. The new procedures are mandatory for a partnership with more than 100 partners or with any flow-through partner, meaning the vast majority of asset management structures will be affected.

Since the Budget Act's enactment, practitioners and affected parties have questioned the practical application of the rules. For example, the original provisions state that, under the default method, the partnership pays the tax deficiency only if an adjustment results in an underpayment of taxes. For an adjustment resulting in over-reporting of income, no refund will be made. Instead, a "true-up" adjustment to income will be made in the year of the audit's completion, causing potential distortion of economics of partners in the reviewed year versus the adjustment year and beyond. The alternative method (also known as the "push-out election") allows partnerships to elect to flow adjustments through to partners in the reviewed year, who then report the income on their individual returns for that year. How this election would apply to a multi-tiered partnership structure is unclear. For further discussion, see Tax Alert 2016-1344.

In early December 2016, House Ways and Means Committee Chairman Kevin Brady (R-TX) introduced the "Tax Technical Corrections Act of 2016," providing welcome guidance and clarification in several areas. The bill includes a push-out option for tiered partnerships, allowing the adjustment to be pushed out to the ultimate taxpayer investors in a multi-tiered partnership structure. The bill would also allow adjustments for overpayments under the push-out method, and would amend default netting rules to take character and individual level limitations into consideration. While this bill was not included in House Speaker Paul Ryan's Continuing Resolution on December 6, 2016, it indicates that Congress is listening to concerns raised by practitioners to the Budget Act audit rules.

Automatic method changes — procedures affecting asset managers

In May 2016, the IRS updated the list of automatic accounting method changes in Revenue Procedure 2016-29, effective for a Form 3115 filed on or after May 5, 2016, for a year of change ending on or after September 30, 2015. While much of the list remained unchanged from prior years, a few differences were relevant to the asset management industry.

For example, the revenue procedure specifically addressed changes to an overall method of accounting from cash to accrual when the change includes in its Section 481(a) adjustment amounts related to certain deferred compensation under Section 457A. Such a change will not be eligible for automatic change procedures and will instead require advance permission from the IRS.

Revenue Procedure 2016-29 also sets out the manner in which to make or revoke a Section 475 mark-to-market election. Starting for tax years ending on or after May 31, 2014, taxpayers may now revoke previously made Section 475(f) mark-to-market elections through an automatic method change. Previously, revocation was only allowed with consent of the Commissioner. While this simplifies the revocation process for taxpayers, careful consideration and planning is recommended. Once revoked, a taxpayer may not re-elect into Section 475 for a previously-marked business for five years. Further, a taxpayer may not change its method from realization to mark-to-market in its final year of business, but it generally may make the reverse change, from mark-to-market to realization, in its final year, provided other eligibility requirements are met. For further details, see Tax Alert 2016-913.

Section 305(c) — accounting method change

A convertible bond's conversion ratio often will be adjusted when a cash dividend is paid on the common stock into which the bond is convertible. Such changes are deemed distributions to the bondholder, normally includible in income under Section 301 and taxable as dividend income. Consequently, US withholding tax would apply to non-US holders of such convertible securities when the underlying common stock is that of a US corporation.

For many years, withholding tax compliance was minimal across the industry because there is no cash payment from which to withhold funds. In recent years, prime brokers have begun to implement withholding.

Certain bondholders may benefit from filing an accounting method change to address the potential liability for the income tax attributable to the conversion rate adjustments. The voluntary change in method would allow a taxpayer to include dividend income as a Section 481(a) adjustment and thus spread it over four years. The IRS has recently noted it is prepared to accept requests for accounting method changes filed on Forms 3115 on this issue. Any such request should be filed soon to increase the likelihood that the method change is granted before the taxpayer must send out Schedules K-1 for its 2016 tax year. For further discussion, see Tax Alert 2016-1787.

Sixth Circuit's surprising treatment of foreign currency contracts

In Wright v. Commissioner, No. 15-1071 (6th Cir. Jan. 7, 2016), the US Court of Appeals for the Sixth Circuit reversed the Tax Court and held that an over-the-counter (OTC) euro foreign currency option was subject to the mark-to-market rules of Section 1256. Section 1256(g)(2) states, in part, that a "foreign currency contract" is a contract "which requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through a regulated futures contracts." The Sixth Circuit concluded that the use of the word OR indicates two independent ways by which a contract may qualify as "foreign currency contract."

As a result, the Sixth Circuit held that a contract "the settlement of which depends" on a value of a major foreign currency is a "foreign currency contract," even if that contract is an option that does not mandate that any settlement occur. Prior to this decision, many practitioners believed that OTC foreign currency options were not subject to Section 1256 and therefore have not been marking such contracts to market. Taxpayers who have taken this position and would like to apply the decision in the Wright case may have to consider an accounting method change, but it is still unclear whether the IRS would be willing to grant such a change, particularly outside the Sixth Circuit. Tax character considerations may be relevant depending on certain elections. For more information, see Tax Alert 2016-87.

Continued focus on limited partner exemption from self-employment tax and new regulations concerning employee status in disregarded entities

In June 2016, another Chief Counsel Memorandum was released in which the limited partner (LP) exemption from self-employment tax under Section 1402 was denied. As a result, all income of a member in an LLC (taxed as a partnership) was subject to self-employment tax. The IRS noted that the LP exemption was intended to apply only to those who "merely invested" in a partnership and not to those that "actively participated" and "performed services." For further details, see Tax Alert 2016-1773.

A similar Chief Counsel Memorandum was released in September 2014 in which the IRS stated that "Congress did not intend to allow service partners in a service partnership acting in the manner of self-employed persons to avoid paying self-employment tax." It remains unclear whether the IRS would make the same assertions if the entity was a state law limited partnership.

On May 4, 2016, the IRS and Treasury issued final, temporary and proposed regulations clarifying the status under the employment tax and employee benefit plan rules of a partner in a partnership that owns a disregarded entity that "employs" the partner under state law. Generally, these regulations provide that a partner who is an "employee" of a DRE owned by the partnership is treated as employed by the partnership owning the DRE. The regulations are generally effective after August 1, 2016.

In the preamble to the regulations, the IRS stated that Revenue Ruling 69-184 reflects its view of the law regarding the partner/employee dual-status issue. The revenue ruling provides that bona fide members of a partnership are not employees of the partnership for purposes of employment tax withholding, and that a partner who devotes his time to the trade or business of the partnership or provides services to the partnership is a self-employed individual. Under Revenue Ruling 69-184, and consistent with the clarification provided in the regulations ,a partner cannot receive a Form W-2 from the DRE, but must instead receive a Schedule K-1 from the partnership with his salary treated as a guaranteed payment. Further, the partner cannot participate in certain employee benefit plans such as a cafeteria plan under Section 125. For additional information, see Tax Alert 2016-827.

Taxpayer challenge to IRS characterization of gain from sale of management company

A petition in a recent Tax Court case, Gavea Investimentos Ltda., Arminio Fraga v. Commissioner, raised questions regarding the character of the gain on a sale of a partnership interest in a management company. In November 2010, a JPMorgan subsidiary purchased a majority interest in Gavea Investimentos Ltda, in which Arminio Fraga was a partner. Fraga took the position that, upon the sale of the management company, the character of that sale was capital gain. In November 2015, the IRS determined that the majority of the fair market value of the partnership ($524 million of the $528 million) was actually attributable to unrealized receivables and should be treated as ordinary income rather than capital gains.

Fraga has petitioned the Tax Court challenging the IRS position, stating that the Service has misapplied Section 741, which states that the sale of a partnership interest generates capital gain rather than ordinary income, and Section 751. If the IRS's position is upheld, this could have implications for the industry regarding the character of income recognized on the sale of partnership interests in management companies.

Final Section 385 regulations — effects on financial services industry

On October 13, 2016, the IRS released final and temporary regulations under Section 385 on the recharacterization of certain debt instruments as equity. Proposed regulations released earlier on April 4, 2016, contained provisions that would have departed significantly from decades of debt-equity case law in related-party contexts and imposed an extraordinary compliance burden. The final and temporary regulations have scaled back many of the provisions of the proposed regulations and provided a variety of exceptions for financial services companies.

In one such change from the proposed regulations, the final and temporary regulations apply only to debt instruments issued by US borrowers; the application to non-US issuers has been reserved for both the documentation requirements (contained in Treas. Reg. Section 1.385-2) and the transactional rules (contained in Treas. Reg. Section 1.385-3). The regulations, however, are structurally designed such that Treasury and IRS could bring debt instruments issued by foreign borrowers within the scope in the future, so this will continue to be an item that bears monitoring.

The final and temporary regulations will apply when a US corporation issues debt to a holder outside of its US consolidated group (e.g., obligations of US subsidiaries owed to non-US parent and brother-sister affiliates, debts between private investment funds that share a corporate owner). S corporations and non-controlled regulated investment companies (RICs) and real estate investment trusts (REITs) are exempt from all aspects of the final and temporary regulations.

The most significant development for financial services companies is that the final and temporary regulations include a broad exception to the transactional rules for instruments issued by "regulated financial companies." Examples include a bank, bank holding company, non-bank financial company, broker/dealer, swap dealer, and most subsidiaries of such companies, subject to certain requirements.

Although regulated financial companies are excepted from the transactional rules of Treas. Reg. Section 1.385-3, they are not excepted from the documentation requirements of Treas. Reg. Section 1.385-2. The documentation requirements could still place a significant administrative burden on financial services companies.

Regarding partnership structures, the final and temporary regulations do not adopt special rules for debt instruments used by investment partnerships, including indebtedness issued by certain "blocker" entities. Controlled partnerships remain subject to the rules. Asset managers should understand if these rules apply, such as in the case of bank-owned funds or a fund-of-one with a corporate investor. Consideration should also be given in transactions to acquire either a US multinational corporation or a non-US target with operations in the US via a US subsidiary of the target. For further discussion, see Tax Alert 2016-1790.

Implications

Consistent with the last few years, legislative, judicial and regulatory activity remains high at the federal level in areas affecting the asset management industry. As we reflect back on the year, now is a good time to review these developments with your tax advisor and understand their implications for your business and your investors.

———————————————