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Dusko Stojkov
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A DC based transactional and tax attorney, financial planner, and a stock market investor, formerly a principal front office capital markets products and loan syndication structurer with a regional European full service bank. Now a tax partner with Perry, Krumsiek & Jack, LLP, a Boston based... More
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Washington International Business Counsel LLP
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  • Thoughts on where SPX is headed
    Based on a method loosely applying DeMark sequential methodology, it appears that SPX (via its proxy SPY) has exhausted its upward trend. The upward trend coincided with the commencement of the FED's POMO bond buyback program last summer (mid-August). Typically, 9 weeks of uptrend coupled with 13 weeks of consolidation indicate an upward trend exhaustion. In order to short this market, one would certainly wait for the trend reversal signs. The above described methodology suggests the following critical levels for the week of: 2/21$127.72 (NYSEARCA:SPY) or $1276.34 (SPX);  2/28 $131.15 (SPY) or $1310.87 (SPX); and 3/7 $133.11 (SPY) or $1329.15 (SPX). A weekly close below those levels would confirm the reversal of the uptrend. 
    Feb 21 10:39 AM | Link | Comment!
  • Structured products desks selling tax advantaged monetization products should pay attention!
    After a recent Tax Court ruling (the Anschutz decision) involving a Donaldson, Lufkin & Jenrette product, structured product departments at investment banks who were selling to high net worth individuals (HNWs) a tax-advantaged monetization strategy involving a prepaid forward structure coupled with a counterparty’s hedging of its position through a stock lending agreement with the forward seller, may want to revisit their structure. 
    In a typical prepaid forward structure, a forward seller (a long party) holds shares of a publicly traded stock appreciated in value. A forward seller and the counterparty would enter into a forward sale and purchase agreement and, contemporaneously, the forward seller would borrow an amount equal to a percentage of the current market value of shares of stock from the counterparty (the “prepaid” element of the structure). The forward seller would also pledge the stock to secure the loan. The forward contract can be settled in cash or in-kind (by delivering shares) and is typically net settled (i.e., payments due by the counterparty, such as dividend or interest payments, are netted against the forward seller’s obligation to deliver shares at maturity. In a variable forward structure, at the conclusion of the loan term, the forward seller would generally to deliver a number of shares to the counterparty or an equivalent amount of cash, which may be different than the amount pledged, depending on whether the stock appreciated or depreciated over the term of the loan. Typically, the long party would have an upside limit and may also have a downside protection. Usual loan terms would be: a mid term maturity, interest bearing, and non-recourse except with respect to the pledged stock. If the stock falls in value by more than a stated amount during the loan term, the forward seller would be required to pledge additional collateral.
    In order for the counterparty to hedge its risk, it  would have to borrow the pledged shares in almost every instance so it can enter a short position on the pledged shares. 
    When it comes to tax consequences, the structure makes sense for the forward selling party, as long as it is able to monetize its position and not pay taxes at the time it pledges stock. The long party would have to pay tax if the Internal Revenue Service (NYSE:IRS) considered it to have sold shares pursuant to the forward prepaid sale.
    Borrowers are not required to pay tax when they secure a non-recourse loan secured by property (including shares of stock), because, typically, pledging property to secure a loan is not considered a taxable sale. Moreover, the variable element in the structure, allowed taxpayers to argue that because the number of shares and the identity of certificates would be unknown until near the settlement date, the transaction should be considered an “open” transaction. Under long standing tax principles, open transactions are not considered taxable. 
    However, if the property (shares) pledge is coupled with another transaction in which the forward seller/borrower is considered to have sold shares to the counterparty, the pledge may be considered a taxable sale even where the value of the pledge property exceeds the loan amount. For instance, the IRS may assert that the long party sold shares in an installment sale where the pledged shares exceed the loan amount in value.
    In a 2003 ruling, the IRS ruled that a pledge of stock in a plain vanilla forward prepaid variable structure coupled with a contemporaneous stock lending agreement did not result in a taxable sale by the forward seller, as long as the forward seller had legal rights and means to reacquire shares identical to the shares pledged as collateral and was not economically compelled to deliver to the counterparty the pledged shares. In a subsequent 2006 ruling, the IRS dealt with a variable forward structure and interpreted the 2003 ruling restrictively to treat as a taxable sale the transaction where the counterparty had a “put” option with the long party in case the counterparty was unable to hedge the pledged stock (the long party also may have relinquished its voting rights upon pledging).  The IRS considered the forward purchase sale and the stock lending transactions stapled and ruled that the forward seller sold its stock at the time the shares of stock were pledged.
    After the 2006 ruling, practitioners went to great lengths to decouple the forward sale and purchase from the stock lending leg of the transaction, most often requiring a 30-90 day time lag between the two legs of the transaction and even that the forward seller be allowed to withhold consent to the counterparty’s borrowing to sell the stock short or pledge additional collateral. Once decoupled, the practitioners argued that the stock lending leg of the transactions would otherwise qualify as a tax-free transaction under the Tax Code stock lending provision (Section 1058). Generally, under the Tax Code’s stock lending provision, a stock lender is not considered to have sold the stock lent to the stock borrower and will not pay tax on the stock lending transfer, if the borrower returns identical securities, makes dividend payments the stock lender would otherwise receive, and the stock lender does not reduce the risk of loss or opportunity for gain as a result of the transfer. Based on legislative history regarding the constructive sales Tax Code provision and the facts of the 2003 ruling, some practitioners considered a twenty-five point spread between the put and the call price sufficient indicia of residual risk.
    Despite the taxpayer’s loss, the Anschutz decision comes as good news to structured products desks and practitioners as it flushed out what works and what does not in terms of decoupling the two legs of the above transaction as well as the requisite variance to avoid the application of the constructive sales rules. 
    In light of the Anschutz decision, investors engaged in these types of transactions should consult with their tax advisors to assess whether they need to restructure the transaction.
    This letter is not intended to provide any tax advice and its contents may not be used to avoid penalties under the Internal Revenue Code.

    Disclosure: None
    Aug 23 7:09 PM | Link | Comment!
  • Impact of Legislative Proposals to Tax Carried Interest on Alternative Asset Managers
    Legislative Proposals Affecting Taxation of Carried Interest
    Two separate bills (H.R. 1439, the “House Bill” and S. Amdt 4369, the “Senate Proposal”) containing the carried interest proposals were introduced in 2010 and both would generally treat net income from an investment services partnership interest as ordinary income for the performance of services.  Though the proposals were not enacted this year and  while it is less likely that the carried interest provision will get more traction during the remainder of the Second Session of the 111th Congress, it is likely that the 112th Congress will revisit the carried interest provision. Accordingly, fund managers and investors alike should pay close attention to the proposed legislation and should understand the impact of the proposed legislation.
    Potential Impact of the House Bill and Senate Proposal
    In addition to increased tax costs, the carried interest provision may also result in unduly harsh reporting requirements and increased compliance costs. For instance, just to determine whether service providing partners are exempted from the carried interest provision would substantially increase compliance costs. A service providing partner’s tax advisor will, at the minimum, have to parse through all records of historic partnership distributions, income, and losses since the service providing partners acquisition of interest, just to determine whether the partner qualifies for the exemption. 
    Also, it is likely that many fund managers as well as fund investors will engage in tax-motivated restructuring of the existing structures just to avoid the tax cost of ordinary income treatment to the manager. Further, some fund managers may increase the carry percentage beyond the traditional 20 percent to defray additional compliance and tax costs. 
    Reclassification of long term capital gains with respect to “tainted” partnership interest.  
    Both the House Bill and the Senate Proposal seek to reclassify net income (as well as net loss) from a partnership interest (regardless of its original pass through character as capital gain or dividend income) as ordinary income (or ordinary loss) for the performance of services. Such income is currently taxed at higher ordinary income rates and is subject to self-employment tax. 
    On the disposition of “tainted” partnership interests (unless such “taint” is preserved), gain (or loss) would be reclassified as ordinary income for the performance of services, despite the existing general partnership tax rule that gain or loss from the disposition of a partnership interest generally is considered as capital gain or loss (except in case of certain recaptures allocable inventory and unrealized receivables). Loss on the disposition of a “tainted” partnership interest is treated as ordinary loss, but only to the extent of the amount by which cumulative reclassified net income exceeds cumulative reclassified net losses under the provision. 

    On the distribution of appreciated property by a partnership to a partner, under the current tax law, neither a partnership nor a partner recognize gain or loss on a distribution to a partner of property or money. Under the Bill and the Proposal, the partnership would recognize gain as if the partnership had sold the property at its fair market value at the time of the distribution.
    Excessive Reach of the Proposal
    Most tax practitioners and even the Staff of the Joint Committee on Taxation consider the reach of the carried interest provision’s reach unduly excessive and administratively burdensome. 
    To illustrate the broad impact of the House Bill, consider a typical investment fund structure in which fund sponsors own interests in a management company and in a partnership having general partnership interests in an investment fund. Under the House Bill, partners’ interest in the general partnership would also be subject to the carried interest provision (though the Senate Proposal would leave the scope of the “indirect” service providers definition to the regulations).
    Carve-outs for certain capital partners may prove insufficient
    Partners and indirect holders of “tainted” partnership interests may still be within the scope of the carried interest provision even if they contribute capital. Generally, the House Bill and the Senate Proposal exempt from the carried interest provision service providing partners who are contributing money or other property to the capital provided to the extent of the partner’s distributive share of partnership items corresponds to the partner's invested capital (i.e., the amount of money or fair value of property contributed to the partnership). However, to the extent partnership allocations are not “straight-up” (e.g., one partner bears losses before others, management fee allocated solely to limited partners, etc.) or in case their partnership holds interests in a lower tier partnership, such capital partners may not be exempted from the carried interest provision in its current proposed form. 
    In addition, a structure in which a capital partner debt financed its acquisition with a partnership guarantee (and has not repaid the debt), such partner’s capital contribution will not be counted for purposes of the exemption (to the extent of the still outstanding debt financing).

    What should investors do?

    Retail investors owning limited partnership interests in fund management companies should not be directly affected by the proposed carried interest legislation because in most cases they won't be considered providers of investment management services to fund advisors, so that there should be no added tax cost upon the disposition of interests. On the other hand, institutional corporate investors may be directly affected to the extent they provide custodial or other services to the fund management companies in which they hold interests, which services may be considered within the purview of the legislative proposal.

    At the same time, fund management companies may incur significant additional expenses to retain their top managers, because the added tax cost of providing fund managers with equity interests may be prohibitive. Accordingly, fund management companies may need to increase the level of cash compensation, significantly increasing total employee compensation expense items and adversely affecting their overall profitability as well as distributions to retail investors.

    While it is too early to scope the overall cost of the proposed legislation on the alternative asset management industry, at the minimum, the industry will be facing increased compensation, and, potentially, restructuring, costs. The market appears to have discounted some added costs alternative asset managers will face, though the market prices may further fall until the uncertainty remains.  

    This note is not intended to provide any tax advice and its contents may not be used to avoid penalties under the Internal Revenue Code.  

    Disclosure: None

    Disclosure: None
    Aug 11 3:53 PM | Link | Comment!
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