BrassTax - December 20, 2023

UK Spearheads Global Commitment to the Crypto-Asset Reporting Framework

The Crypto-Asset Reporting Framework (“CARF”), is the OECD’s flagship tax transparency standard to help combat criminal activity using crypto-assets to evade taxation. The key aspects of the CARF were covered in the article “Update: OECD Crypto-Asset Reporting Framework” published in Brass Tax on November 29, 2022.

As a brief reminder, the CARF is expected to facilitate the tax transparency of transactions relating to crypto-assets through building on the existing infrastructure that tax authorities around the world use to share tax information with each other, namely the Common Reporting Standard (“CRS”).

The implementation of the CARF will mean that crypto-asset platforms will need to commence collecting and sharing taxpayer information with taxation authorities (which such platforms currently do not do).  The result of that change should ensure that tax authorities can exchange information to enforce compliance with applicable tax laws that relate to crypto-assets as a class. The CARF is expected to take effect from 2027, giving stakeholders time to prepare for the changes in reporting arrangements.

The next step forward on the road to the world’s tax authorities implementing the CARF is for the OECD, along with those tax authorities, to progress legal and operational instruments that will facilitate the international exchange of information collected under the CARF. To that end, in an historic joint statement with 48 countries (including the United States) published on 10 November 2023, the United Kingdom has spearheaded a first of its kind global commitment to:

1) welcome the international standard on the automatic exchange of information between tax authorities for transactions relating to crypto-assets, as developed by the CARF;

2) swiftly transpose the CARF into domestic law and activate exchange agreements in time for information exchanges to commence in 2027; and

3) where the jurisdictions are signatory jurisdictions to the CRS, implement crypto-asset-related amendments to the CRS standard, as agreed by the OECD earlier this year.

Promptly after this, on 29 November 2023, HMRC launched an online voluntary disclosure facility specifically aimed at encouraging tax payers to disclose any unpaid tax on crypto-assets.

Future financial services regulatory framework for crypto-asset consultation

The UK’s commitment to becoming a global hub for crypto-asset technologies can be further evidenced by the publication of the public consultation on the future financial services regulatory framework for crypto-assets earlier this year in February.  

The purpose of the consultation was to gather evidence and responses from industry experts and other interested parties to ensure that the regulatory framework implemented in the UK provides: (1) the clarity needed for crypto platforms to invest and innovate; and (2) the protections necessary for customers to confidently continue using these technologies, in each case within the UK.

The response to the consultation, published in October 2023, also touches on the government’s broader views on “surveillance and information sharing.” The response notes that existing market abuse regimes and supporting infrastructure for traditional financial services asset classes were developed over many decades. Therefore, expecting the same level of sophistication and coordination on day one of the crypto-assets regime is unrealistic.

It is likely that a staggered implementation of domestic data-sharing obligations will take place in order to maintain a fair and orderly crypto-asset trading environment within the United Kingdom.  It will be interesting, therefore, to see how and to what extent the CARF is implemented into domestic legislation by the 2027 timeline and whether any such automatic exchange of information regime will be effective.

Crossing the U.S. Trade or Business Line

YA Global Investments, LP (“YA Global”), a foreign investment fund that provided funding to portfolio companies in exchange for stock, convertible debentures, promissory notes and warrants, engaged U.S.-based Yorkville Advisors LLC (“Yorkville”) to manage its portfolio. YA Global took the position that it did not have any income that was effectively connected with a U.S. trade or business.  Upon audit, the IRS adjusted YA Global’s tax returns for its taxable years 2006 through 2009 on the basis that it was in fact engaged in a U.S. trade or business and therefore was liable for withholding taxes on income that was allocable to its foreign partners.  YA Global strongly contested this determination.

The Tax Court agreed with the IRS that YA Global was engaged in a U.S. trade or business and thus should have been withholding on allocations to foreign partners.  The court also held that YA global was a dealer under Code Section 475 and thus should have been marking its assets to market.

Set forth below are the court’s key findings.

Yorkville Acted as YA Global’s Agent

In a threshold inquiry, the court determined that Yorkville was acting as an agent for YA Global and therefore attributed Yorkville’s U.S. activities to YA Global for purposes of determining whether it was engaged in a U.S. trade or business. The court followed the Restatement (Third) of Agency in finding that Yorkville was the agent of YA Global because YA Global had the power to give interim instructions to Yorkville after the onset of the parties’ relationship.  The court also found it to be significant that the management agreements between the parties used the word “agent” in describing the relationship of Yorkville to YA Global.

Portfolio Companies’ Fees to YA Global Were More Than Additional Payments for Use of Capital

YA Global was in the business of providing funding to portfolio companies in the form of convertible debentures, standby equity distribution agreements (SEDAs) and other securities. In addition to typical investment returns, YA Global received fees from the portfolio companies it funded. The court rejected YA Global’s contention that these fees were merely additional compensation for the use of capital. Instead, the court found that the fees were intended to cover the costs of additional services that Yorkville provided to the portfolio companies and that the portfolio companies received benefits from YA Global beyond the use of capital. Once again, the court attached significance to labels, noting that some of the fees were called “monitoring” and “structuring” fees. The court also rejected YA Global’s contention that  SEDA commitment fees were essentially the same as premiums paid in typical put options, explaining that, unlike in an option, the price YA Global would pay for stock issued for a SEDA advance would always be at a discount to market price.

YA Global Was Engaged in a U.S. Trade or Business

The court found that the partnership’s activities produced taxable income that was effectively connected with its U.S. trade or business. The court reasoned that YA Global’s activities (conducted through Yorkville as its agent) were continuous, regular and engaged in for profit, and that its activities went beyond the scope of a typical investor who invests capital or manages investments, specifically finding that YA Global’s activities did not qualify for the securities trading safe harbor under Code Section 864(b)(2)(A).

YA Global Was a Dealer in Securities and Subject to the Mark-To-Market Rules

The court concluded that YA Global was a “dealer in securities” because it held itself out as being willing and able to provide capital to portfolio companies who were its “customers” within the meaning of Code Section 475. The court explained that “customers” under the regulations are “those with whom the taxpayer does what it regularly holds itself out” to do. Additionally, the court held that YA Global did not satisfy the identification requirement of the exception for securities held for investment because its agreements failed to explicitly state, or clearly identify, that the security was described in the relevant Code sections.

Lesson Learned

This was a lengthy and complicated case, and there is more to say about it than space allows, but here are some key points of caution.  The court held the parties to their own labels.  The court construed the securities trading safe harbor narrowly and was skeptical of activities that went beyond the mere provision of capital and buying and selling based on market swings.  The court viewed fees as being paid for services rather than for the use of capital.  The court applied the dealer regulations under Section 475 in an expansive manner. 

While the facts of this case may seem extreme, taxpayers who are engaged in activities that extend beyond typical investment and trading activities would be well advised to heed these lessons to ensure that they don’t end up on the wrong side of the U.S. trade or business (or dealer) line.

Exchange Trust Certificates in REMIC Transactions Qualify as Stripped Bonds or Coupons

On November 24, 2023, the IRS released PLR 202347001, ruling that certificates issued from an “exchange trust” qualify as stripped bonds or stripped coupons within the meaning of Code Section 1286.

The taxpayer in the PLR issues mortgage-backed securities in which mortgage loans are deposited into a trust that is structured as either a grantor trust or a real estate mortgage investment conduit (“REMIC”).  The grantor trust issues pass-through certificates that represent ownership of the underlying mortgage loans, and the REMIC issues REMIC regular interests that are treated as debt instruments for tax purposes.  In each case, holders of trust certificates are entitled to receive income and principal from the mortgage loans.

The PLR describes an exchange trust mechanism in which holders of the trust certificates are permitted to exchange their certificates for certain “exchange certificates” that have terms that vary from the terms of the initial certificates.  For example, a holder of a trust certificate entitled to $100 of principal and interest at a rate of 6% may exchange the initial certificate for two new exchange certificates—one entitled to $100 of principal and interest at a rate of 4%, and the other entitled to interest that accrues on $100 at a rate of 2%.  These exchange certificates are stripped bonds and stripped coupons because they represent a “strip” off the initial certificate that is equal to a fixed number of basis points.

The PLR also rules favorably for the taxpayer in the more analytically challenging case when an initial certificate with a fixed rate is exchanged for two new exchange certificates that represent an inverse floater pair whose rates are based on a benchmark (e.g., SOFR) such that the “strips” are not fixed.  For example, the holder of the trust certificate with a fixed rate of 6% may exchange it for two new certificates—one with an interest rate equal to SOFR plus 2% (with a cap of 6%) and the other with an interest rate equal to 6% minus the sum of SOFR plus 2% (with a floor of 0%).  When paired together, the two exchange certificates always have a combined rate of 6%.  The PLR confirms that these exchange certificates qualify as stripped bonds and stripped coupons—even though these “strips” vary based on a benchmark—and that the exchange trust in this example qualifies as a fixed investment trust.

The IRS has now privately ruled favorably on the use of exchange trusts for inverse floater pairs a few times (e.g., PLR 201229003 and PLR 200624005).  It would certainly be helpful if the IRS would issue formal, precedential guidance on these exchange trusts considering their desired use in mortgage securitizations.

Beware of Monsters

In a rare application of Section 1234A, the Tax Court has held that extending the settlement dates of a set of variable prepaid forward contracts (“VPFCs”) was an exchange for a second set of VPFCs that terminated the taxpayer’s underlying obligations under the first set, resulting in short-term capital gain of $71.7 million to the Estate of McKelvey (the “Estate”).

In 2007, Andrew McKelvey entered into multiple VPFCs with two different investment banks.  In exchange for substantial cash prepayments, the VPFCs required McKelvey to deliver, at various settlement dates in 2008, a number of shares in Monster Worldwide Inc. (“Monster”) (a company that McKelvey founded) that would vary with Monster’s share price at the time of the settlement dates. In 2008, McKelvey and the banks extended the settlement dates of the initial set of VPFCs to 2010.  McKelvey died later in 2008.  The Estate did not report any gain or loss for that year in relation to the extensions. The IRS claimed that the decedent realized capital gain upon executing the extensions in 2008.

In the initial case, the Tax Court held that the Estate’s treatment of the first set of VPFCs as remaining open after the extensions was appropriate and that the extensions did not constitute a sale or exchange of property that resulted in gain.  The Second Circuit reversed, determining that the extensions of the VPFCs resulted in the replacement of the first set of VPFCs for a second set of VPFCs.  The case was then remanded to the Tax Court to determine whether this replacement was a termination for purposes of Section 1234A, and if so, the amount of gain realized. Section 1234A treats gain or loss attributable to termination of a right or obligation with respect to a capital asset as gain or loss from the sale of a capital asset.

The Tax Court held that the replacement of the first set of VPFCs for the second set was in fact a termination of the first set.  The court analogized VPFCs to option contracts and said that the exchange was effectively a repurchase of options held by the investment banks, which repurchase was a closing transaction that terminated the obligations of McKelvey with respect to the first set of VPFCs. Having found the exchange to be a termination, the court undertook a rather straightforward application of Section 1234A to find that the termination resulted in short term capital gain.

The final question was how to calculate the gain.  The court applied Section 1001, dealing with the sale or disposition of property, despite admitting that McKelvey’s positions with respect to the VPFCs were not property but rather obligations.  In doing so, the court reasoned that the nature of the underlying shares as property warranted the application of Section 1001.  With that decided, the court calculated the gain by subtracting payments to the investment banks and the outstanding liability as a result of the second set of VPFCs (determined by applying the Black-Sholes option pricing formula) from the prepayment amounts received. 

In light of this case, taxpayers should carefully consider the tax consequences of amending their derivatives and other financial contracts.

Moore Bark Than Bite? Supreme Court Weighs In

Unless you have been living under a rock—as we tax lawyers are wont to do—you have probably been following Moore v. United States, which we last discussed here.  On December 5, the tax community stepped into the spotlight (symbolically, of course) to hear the oral arguments before the Supreme Court.

The question presented before the Supreme Court is “whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.” 

Specifically, the Moores are challenging the one-time transition tax enacted under the Tax Cuts and Jobs Act (“TCJA”) on earnings that have accumulated overseas. 

The Moores argue that the Sixteenth Amendment allows Congress to tax income only after a realization event and that the Constitution also prohibits Congress from imposing direct taxes without apportionment.

The Supreme Court seemed to be skeptical of the Moores’ argument from the outset, echoing the concerns of anxious tax lawyers and an explicit warning from the Solicitor General that invalidating the tax would “wreak havoc on the proper operation of the tax code.”

Justice Alito immediately acknowledged the “far-reaching consequences” of invalidating the tax, plainly stating that he was “quite concerned by the potential implications of the [Moores’] argument.”

Justice Kagan said that a decision for the Moores would put “very established taxation schemes at risk,” and specifically mentioned Subpart F, S corporations, partnerships and taxing on an accrual basis.  Counsel for the Moores conceded that Subpart F was constitutional, which the Solicitor General called an “incredibly significant concession” because the transition tax operates in the same way.

The Moores argue that Congress does not have the power to tax income that has not been realized to the taxpayer, but a few of the justices pointed out that the corporation unquestionably realized income.  These justices seemed to suggest that the issue is whether it is fair to attribute such income to the Moores as minority shareholders.

Chief Justice Roberts began by stating that “there certainly is realization here by the corporation.”  Later, Justice Kavanaugh remarked that “there was realized income here to the entity.”  Justice Sotomayor asked why the attribution of income to partners is always permitted, but the attribution to shareholders is not.

Perhaps the nail in the coffin was when Chief Justice Roberts asked “what’s left to defend” after the Solicitor General “stabbed Macomber,” which is the primary case on which the Moores have relied.  Chief Justice Roberts acknowledged that Macomber has “certainly narrowed” over time, although he and others asked how to uphold the tax and still maintain some limits on Congress’s power to tax. 

Further, the justices seemed to approve the Solicitor General’s description of a direct tax as one that looks “to the total value of the asset . . . at a particular point in time,” which is “totally different from an income tax where you are taxing the increment of gain over time and generally only doing it one time.”  The Solicitor General argued that, before the enactment of the one-time transition tax, these earnings were able to accumulate offshore tax-free, and the government should not lose the opportunity to tax these earnings as income merely because they had previously been subject to a period of tax deferral.

All in all, the tax community may finally have some relief as the Supreme Court seems likely to uphold the tax.  Despite this cautious optimism, tax professionals and legal scholars alike eagerly await the resolution of this significant and closely watched case.