September 17, 2021
Tax plan in House Ways & Means reconciliation bill includes several proposals that would affect financial transactions and digital assets
On September 13, 2021, the House Ways and Means Committee released the tax portion of its reconciliation bill (HW&M proposal or Proposal) and a section-by-section summary of the tax proposals, including new rules addressing financial transactions and digital assets (as defined herein). The HW&M proposal contains a proposed increase to the overall corporate tax rate to 26.5%, significant changes to the international tax landscape, and a new interest expense limitation and other corresponding rules under IRC Section 163. For more information on the international provisions, see Tax Alert 2021-9023. Additionally, the HW&M proposal contains additional provisions with far-reaching implications. With important exceptions, most of these provisions would be effective for tax years beginning after December 31, 2021.
This Alert highlights the significant tax proposals impacting financial transactions and digital assets, including proposed changes to IRC Sections 165(g), 267, 871, 1091, and 1259.
IRC Sections 165(g) and 267 — Modifications to treatment of certain losses
IRC Section 165(g) generally treats a loss from a worthless security that is a capital asset as arising from the sale or exchange of a capital asset on the last day of the tax year. The Proposal would modify these rules by (i) fixing the date any loss is realized as the time of the identifiable event establishing worthlessness, (ii) treating certain debt issued by a partnership as a "security" within the meaning of IRC Section 165(g)(2), and (iii) providing that a loss from a worthless partnership interest is subject to the same character rules as a loss on a sale of a partnership interest under IRC Section 741. The modifications would be applicable to losses arising in tax years beginning after December 31, 2021.
The Proposal would effectively prohibit taxpayers from claiming an ordinary deduction for (i) losses with respect to debt issued in registered form by a partnership and (ii) losses arising from worthless partnership interests. Instead, any loss would be characterized as capital and as having been realized as of the day of the event establishing worthlessness under the modified rules of IRC Section 165.
The Proposal also modifies IRC Section 267 to defer recognition of any loss realized on the stock or securities of a subsidiary liquidating into its parent under IRC Section 331. New IRC Section 267(h) would defer that loss until the transferee corporation disposed of substantially all of the property distributed in the liquidation to a third party. The amendments are applicable to liquidations occurring after the date the legislation is enacted. This provision would effectively eliminate taxpayers' ability to enter into so-called Granite Trust planning transactions, pursuant to which capital losses can be recognized by liquidating an insolvent subsidiary. Importantly, the proposed rule only applies to losses and has no impact on gains realized under IRC Section 331.
The Proposal's reference to "securities" also would expand the class of instruments on which losses may be deferred to include outstanding debt instruments of the liquidating corporation. Under the Proposal, a debt instrument issued by a liquidating subsidiary that is extinguished in connection with the liquidation is treated as a "sale or exchange" for purposes of IRC Section 267. However, the Proposal does not specify whether it only applies to debt held by the minority shareholder or to all debt held by related parties. Moreover, the Proposal does not offer any certainty as to the proper treatment of such a transaction under current law.
IRC Section 871(h) — Modifications to portfolio interest exemption
IRC Sections 871 and 881 generally exempt from withholding tax any "portfolio interest" received by a nonresident individual or foreign corporation. Under current law, portfolio interest does not include any interest received by a 10% shareholder. In the case of a corporate issuer, a 10% shareholder means any person who owns 10% or more of the total combined voting power of all classes of stock of the issuing corporation entitled to vote. The Proposal would expand the definition of 10% shareholder under IRC Section 871(h) to also include any person who owns 10% or more of the total value of the stock of the issuing corporation.
The amendment to IRC Section 871(h) would be effective for obligations issued after the date the legislation is enacted. Taxpayers intending to rely on the portfolio interest exemption with respect to new debt investments may need to reevaluate ownership interests in issuing corporations to account for certain high-value, low-voting rights shareholders that hold corporate debt.
IRC Section 871(m) — Certain partnership-interest derivatives
IRC Section 871(m)(1) generally provides that certain "dividend equivalents" are treated as a dividend from sources within the US for purposes of withholding taxes under IRC Section 881(a). IRC Section 871(m)(2) defines the term "dividend equivalent" to include substitute payments with respect to certain securities lending or sale-repurchase transactions and payments made pursuant to certain specified notional principal contracts.
New IRC Section 871(m)(8) expands the rule to treat certain payments as a dividend equivalents subject to withholding tax. Specifically, the new rule would apply to any payment made pursuant to a sale-repurchase transaction or a specified notional principal contract that is determined by reference to any income or gain from an interest in a specified partnership. For these purposes, a specified partnership means any publicly traded partnership (as defined in IRC Section 7704(b)) that is not treated as a corporation under IRC Section 7704(b), or any other partnership described in regulations issued by the Secretary of the Treasury (the Secretary). Any payment subject to this rule would be treated as a dividend paid by a domestic corporation for purposes of the withholding rules. The Proposal would provide exceptions for transactions that do not have the potential for tax avoidance (as determined by the Secretary), or for payments that would be either exempt from tax or foreign source income paid to a nonresident alien individual.
Many non-US taxpayers currently gain exposure to publicly traded partnerships through interests in total return swaps on such partnership interests and take the position that resulting income is free of US tax. This Proposal would subject such taxpayers to a 30% withholding tax on their income from such swaps. Notably, the Joint Committee on Taxation description of the Proposal, released September 13, 2021 (the JCT Report), provides that the publicly traded partnership itself is responsible for determining the portion of the notional principal contract that is subject to the new sourcing rule under proposed IRC Section 871(m)(8), and must provide the relevant information in notices to the relevant withholding agent.1Though this language is not in the proposed legislative text itself, the Proposal does grant authority to the Secretary to implement regulations similar to the rules under IRC Section 1446(f) to determine the manner in which the amount of income and gain is determined for purposes of IRC Section 1441 in the case of amounts treated as a dividend equivalent under proposed IRC Section 871(m)(8).
The amendments would be applicable to payments made on or after the date that is 180 days after the date of enactment. The six-month delayed effective date is likely provided to allow for affected taxpayers to implement necessary systems and controls to comply with the new rule.
IRC Section 1091 — Wash sales by related parties; wash sales of specified assets
IRC Section 1091 generally prohibits a deduction for losses realized from the sale or other disposition of shares, stock, or securities where it appears the taxpayer has acquired (or has entered into a contract or option to acquire) substantially identical stock or securities in the 60-day period beginning 30 days prior to the date of the original disposition. The rule generally prevents taxpayers from claiming losses on assets while still retaining an interest in that asset. However, under current law, the basis of any stock or securities acquired in a wash sale is increased for the loss disallowed by IRC Section 1091. Thus, any loss is generally preserved.
The Proposal would modify these rules to (i) apply when a related party2 acquires substantially identical stock, and (ii) expand the types of assets to which the provision may apply. Under the Proposal, IRC Section 1091 would apply to the following assets (1) any security described in IRC Section 475(c)(2)(A)-(E) (e.g., partnership interests, debt obligations, notional principal contracts), (2) any foreign currency, (3) any commodity described in IRC Section 1091(e)(2)(A)-(C), and (4) any digital representation of value which is recorded on a cryptographically secured distribution ledger (i.e., "digital assets") or any similar technology as specified by the Secretary.
Moreover, proposed IRC Section 1091(d) would amend the general loss deferral rule to provide that the basis of the acquired assets is increased for a disallowed loss only in cases where the taxpayer (or taxpayer's spouse) acquires substantially identical specified assets during the relevant period. Thus, a wash sale triggered by a related party (other than a spouse) acquiring substantially identical specified assets results in a permanent loss disallowance rather than deferral.
New IRC Section 1091(i) would provide exceptions to the application of the wash sale rules for dispositions of certain foreign currency or commodity positions that are directly related to the business needs of the taxpayer or are part of a hedging transaction (as defined in IRC Section 1221(b)(2)).
The proposed amendments would apply to sales and other dispositions after December 31, 2021. Similar to the new rules under proposed IRC Section 1259 (described below), the Proposal greatly expands the types of assets and transactions that may be subject to loss deferral under the wash sale rules. However, taxpayers may be able to avail themselves of the new hedging and business needs exceptions, although the scope of the business needs exception, in particular, is unclear (though guidance under IRC Sections 1221 and 954(c)(1)(D) (and corresponding regulations) may be analogous). The Proposal, however, would alter the wash sale rules (in certain circumstances) so that the result is a loss disallowance, instead of a loss deferral. Thus, taxpayers should consider both the US federal income tax and financial accounting implications of the possible permanent disallowance of these losses.
IRC Section 1259 — Constructive sales
IRC Section 1259 generally requires taxpayers to recognize gains with respect to an appreciated financial position as if the position was sold for its fair market value on the date of the constructive sale. An appreciated financial position generally means any position with respect to any stock, debt instrument, or partnership interest with built-in gain. A taxpayer is treated as having made a constructive sale of an appreciated financial position if the taxpayer (or related person) (1) enters into a short sale of the same or substantially identical property, (2) enters into an offsetting notional principal contract with respect to the same or substantially identical property, (3) enters into a futures or forward contract to deliver the same or substantially identical property, or (4) in the case of an appreciated financial position that is a short sale or a contract described in (2) or (3), acquires the same or substantially identical property. The rules are generally intended to prevent taxpayers from monetizing investment gains without realizing taxable gains.
The Proposal would expand the definition of an "appreciated financial position" to include positions in "digital assets." New IRC Section 1259(d) would define "digital asset" in the same manner as the proposed modifications to IRC Section 1091, discussed above. In addition, the Proposal would modify IRC Section 1259(c)(1)(D) to provide that a constructive sale occurs when a taxpayer acquires "or enters into a contract to acquire" the same or substantially identical property in cases where the appreciated financial position is a short sale or contract described in IRC Section 1259(c)(1)(B) or (C).
The modified rules generally would apply to constructive sales entered into after the date the legislation is enacted. As a result, taxpayers, particularly those active in cryptocurrency transactions, should begin to identify positions that may be impacted by the new proposal.
The HW&M proposal includes several important provisions that impact financial transactions and digital assets, and further demonstrates a renewed focus on overhauling the taxation of financial derivative transactions.3 While the proposals included in Senator Wyden's Modernization of Derivatives Act focused on certain timing and sourcing rules, the Proposal both narrows a taxpayer's ability to claim ordinary losses and deductions that arise from particular transactions and expands the types of transactions and categories of assets that may give rise to adverse US federal income tax consequences. Taxpayers should begin to identify transactions and positions that may be impacted by these new provisions and continue to monitor the legislative process for potential changes to these proposals.
1 See Staff of the Joint Committee on Taxation, "Description of the Chairman's Amendment in the Nature of a Substitute to the Committee Print Relating to Infrastructure Financing (Subtitle F), Green Energy (Subtitle G), the Social Safety Net (Subtitle H), and Prescription Drug Pricing (Subtitle J)," at 51 (JCX-43-21) (Sept. 13, 2021).
2 New IRC Section 1091(i) provides that the term "related party" includes the taxpayer's spouse, and certain dependents, as well as certain controlled entities (within the meaning of IRC Section 954(d)(3)), certain retirement plans, and accounts under qualified tuition programs described in IRC Section 529.
3 Tax Alert 2021-1504. On August 5, 2021, Senate Finance Committee Chairman Ron Wyden (D-OR) introduced the Modernization of Derivatives Act, which would change the tax treatment of financial derivative transactions.