February. Commissioner. activities. clarifying

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1 February 1, 2011 The Honorable Douglas H. Shulman Commissioner Internal Revenue Service Room Constitution Avenue, NW Washington, DC Dear Commissioner Shulman, On behalf of The Clearing House Association, L.L.C. ( The Clearing House ), 1 I wanted to thank you for meeting with us and for the opportunity to provide you with an overview of the activities of The Clearing House and its affiliate, The Clearing House Payments Company. During our meeting, you requested that we furnish you with a list of the major areas of current Treasury regulations which, in our members view, are most in need of additional, clarifying guidance. We know from our discussion with you and your recent public remarks at the 23rd Annual Institute on Current Issues in International Taxation (the Institute ) that the IRS is focused on promptly issuing additional guidance to implement the provisions of the Foreign Account Tax Compliance Act ( FATCA ) provisions of the Hiring Incentives to Restore Employment Act ( HIRE ). Accordingly, we have not listed FATCA guidance below, althoughh it is an area of great interest and concern to our members. We would like to take this opportunity to identify certain other tax regulatory areas about which our members are concerned. A number of these have become more important due to recent non tax reform measures, such as the Dodd Frank Walll Street Reform and Consumer Protection Act ( Dodd Frank ) and Basel III. Executivee Summary The Clearing House shares your views stated at the Institute (and elsewhere) that taxpayers and tax authorities want a balanced tax administration system that provides: Certainty regarding a taxpayer s obligations sooner rather than later; 1 Established in 1853, The Clearing House is the nation s oldest banking association and payments company. It is owned by the world s largest commercial banks, which collectively employ 1.4 million people in the United States and hold more than half of all U.S. deposits. The Clearing House Association L.L.C. is a nonpartisan advocacy organization representing through regulatory comment letters, amicus briefs and white papers the interests of its owner banks on a variety of systemically important banking issues. Its affiliate, The Clearing House Payments Company L.L.C., provides payment, clearing, and settlement services to its member banks and other financial institutions, clearing almost $2 trillion daily and representing nearly half of the automated clearing house, funds transfer, and check image payments made in the U.S. See The Clearing House s web page at

2 The Honorable Douglas H. Shulman 2 February 1, 2011 Consistent treatment across taxpayers; and An efficient use of government and taxpayer resources by focusing on the issues and taxpayers that pose the greatest risk of noncompliance. IR (December 9, 2010). Specifically, The Clearing House: 1. Book tax conformity. recommends increased reliance on book tax conformity generally, and in particular regarding Section 475 of the Internal Revenue Code of 1986, as amended (the Code ), and nonaccrual loans, to enable the government and taxpayers to more efficiently use their limited resources to ensure compliance with taxpayer reporting obligations; recommends a purposive approach under Code Section 382 regarding increases in ownership by less than 5% shareholders and other situations not involving the potential for abuse under Code Section 382; suggests that the IRS reconsider its position regarding the all or nothing rule and other unnecessarily punitive tax consequences of the dual consolidated loss ( DCL ) rules under Code Section 1503(d) and the regulations thereunder in order to allow large commercial banks to restructure their operations more easily to comply with various provisions of Dodd Frank and the Basel III capital and liquidity requirements; and suggests that the IRS clarify that swaps with upfront payments that are notional principal contracts ( NPCs ) cleared through a U.S. clearinghouse by a controlled foreign corporation ( CFC ) of a U.S. shareholder that owns an interest in the clearinghouse do not create deemed loans under Code Section 956, in order to ensure that the decision of where to clear foreign executed swaps is neutral (i.e., not affected) from a tax perspective. The Clearing House strongly believes that increased reliance on book tax conformity would be beneficial in resolving certain issues regarding the timing of income and expense for both taxpayers and the government. In many situations, increased reliance on book income and expense reported on financial statements would reduce conflicts, increase certainty and simplify audits for taxpayers and the IRS. We describe two specific examples below: A. Code Section 475. Code Section 475(g) and the legislative history to Code Section 475 authorize the Secretary to issue regulations to permit the use of valuation methodologies that reduce the administrative burden of compliance on the taxpayer but clearly reflect income

3 The Honorable Douglas H. Shulman 3 February 1, 2011 for U.S. Federal income tax purposes. 2 The preamble to the final Treasury regulations on valuation safe harbors in Code Section 475 recognizes that it is sometimes difficult to determine the fair market value of certain securities and commodities, and that [t]his has impeded the efficient administration of the mark to market system under section The preamble states further that the regulations were issued with a view to improving the administrability of the valuation requirements of section The regulations utilize the bid ask spreads in the marketplace to define a safe harbor for taxpayers that elect to use book values of certain positions as the fair market values of these positions for purposes of Code Section However, the safe harbor requires that taxpayers use a valuation method which consistently produces values that are closer to the mid market values than they are to the bid or ask values. 6 Therefore, taxpayers are not permitted to use book values if their book valuation method too often produces values that are at or near the bid or ask value (subject to an exception for securities listed on a qualified board or exchange). 7 In contrast, U.S. GAAP permits the use of bid and ask prices to value such positions or any price between that is most representative of fair value in the circumstances, and permits using mid market price as a practical expedient. 8 Taxpayers who follow these U.S. GAAP rules are unable to avail themselves of the Treasury regulation safe harbor, notwithstanding that their valuation method is in accordance with U.S. GAAP and used by them for financial statement reporting purposes. The Clearing House recommends that the safe harbor be restructured as a safe harbor requiring conformity to the values reflected on the financial statements in compliance with FAS 157 or IFRS 9, or the eventual converged accounting standard to be adopted by the Financial Accounting Standards Board (the FASB ) and the International Accounting Standards Board (the IASB ). This recommendation reflects recognition of the reality that entities which are regulated or publicly traded have a disincentive to minimize their reported financial statement income under U.S. GAAP or IFRS. The values reported on the financial statements are used for numerous other purposes, including regulatory reporting, and are closely scrutinized by regulatory authorities and external auditors. 9 The Treasury regulations 10 also require that changes in the value of positions reported under the safe harbor must be reflected on the taxpayer s income statement (and not on its audited balance sheet or other reliable financial reports). As a result, changes in fair values of H.R. Conf. Rep. No , 103rd Cong., 1st Sess., at 613 (1993). T.D. 9328, I.R.B. 1. Id. Treas. Reg (a) 4(a)(2). Treas. Reg (d)(3)(i)(B). Treas. Reg (d)(3)(i)(A). Statement of Financial Accounting Standards 157, codified as ASC Codification Topic 820. We also note that differences between values used for financial reporting purposes and mid market valuations generally are short term, temporary (i.e., timing) differences. 10 Treas. Reg (a) 4(d)(2)(ii).

4 The Honorable Douglas H. Shulman 4 February 1, 2011 positions that are reported in the balance sheet through Other Comprehensive Income ( OCI ), such as available for sale securities, cash flow hedges and certain currency hedges, do not qualify for the safe harbor. The changes in fair value of those positions are not reflected in the income statement until they are subsequently realized (with an exception for certain otherthan temporary impairments), at which time they will be reflected as a component of taxable income. The Clearing House disagrees with this potential disparate treatment under Code Section 475 of a timing difference for the same class of securities (or, indeed the same securities), merely due to the specific securities accounting classification. It seems illogical that changes in fair market value of securities classified as available for sale do not qualify for the safe harbor until some point in the future when they are realized and reflected in the income statement, but those same changes in value in the same class of securities do qualify currently for the safe harbor if the securities are held in the taxpayer s trading portfolio. Because the same valuation method is used to value both positions for book purposes, they should be given the same treatment under the safe harbor. Further, the safe harbor requires that financial statements be prepared in accordance with U.S. GAAP. 11 The SEC recently issued a progress report on its Work Plan for incorporating IFRS standards into the U.S. financial reporting system. 12 Given the global effort towards convergence of accounting standards for financial instruments announced by the IASB and the FASB, IFRS taxpayers should be permitted to use the safe harbor. 13 B. Nonaccrual loans. There has long been a debate between the IRS and taxpayers over the taxability of interest on loans that are past due. Bank regulatory reporting guidance generally requires that a bank cease recognizing income for any accrued but uncollected interest and reverse any previously recognized uncollected interest income for loans placed on nonaccrual status for regulatory purposes (e.g., generally on which principal or interest payments are in default for 90 days or more). The IRS, however, has formally taken the position that it disagrees with this treatment and that current recognition of income is required if there is a reasonable expectancy of payment. 14 As a result, we understand that in individual audits there has often been an agreement between the IRS and the individual taxpayer that allows a certain percentage of interest income to be reversed. Unfortunately, this approach has meant that there is no certainty of consistent standards applied across taxpayers or even applied to the same taxpayer for successive audit cycles. The IRS has focused on this by designating the issue of non performing loans as a Tier II Issue, creating an Issue Management Team for the issue and, most recently in March 2010, Treas. Reg (a) 4(h). Office of the Chief Accountant, Division of Corporation Finance, U.S. Securities and Exchange Commission, Progress Report (October 29, 2010), sec.gov/spotlight/globalaccountingstandards/globalaccountingstandards.pdf. 13 See Notice , 2008 I.R.B. 35, in which Treasury and the IRS requested comments on the differences between U.S. GAAP valuation standards and those in IFRS, especially differences between mark to market valuation under IFRS and under U.S. GAAP. 14 Rev. Rul , C.B. 1278; see also Rev. Proc , C.B 1289.

5 The Honorable Douglas H. Shulman 5 February 1, 2011 issuing an LMSB Memorandum providing direction to the field. 15 The Memorandum explains that a primary purpose of the IMT is to ensure that when these issues are identified for audit, they are examined fairly and consistently for all taxpayers. The Memorandum also instructs field agents to contact the IRS LMSB Banking Technical Advisor for advice and assistance and to ensure consistent and uniform treatment of this issue. Notwithstanding these efforts, we believe that book tax conformity would be a better solution. We believe that where loan interest and principal payments have not been made for 90 days, it is reasonable to assume that interest on that loan is unlikely to be paid. If taxpayers were permitted to rely on book treatment in those circumstances, the government resources previously taken up auditing these issues could be redeployed to other priorities. Beyond the compliance benefits, book tax conformity on timing issues has become more important in light of U.S. and international initiatives to reform capital and liquidity regulation (such as Basel III). Timing differences between the recognition of certain items for book purposes and for U.S. tax purposes create deferred tax assets and liabilities. We note that the Basel III framework requires deferred tax assets to be deducted from Tier 1 capital above certain individual and combined (with mortgage servicing rights and investments in unconsolidated subsidiaries) caps and specifies that the portion not deducted will be riskweighted 250%. If the Basel III framework is adopted, deferred tax assets will have an even greater negative capital impact than they do currently; thus, a failure to move closer to booktax conformity on these and other timing issues will be even more detrimental to banks. In summary, The Clearing House believes that the Treasury and the IRS should move towards more book tax conformity. This shift in approach would benefit both the IRS and taxpayers by reducing time consuming and resource intensive conflicts without sacrificing the important goal of having taxes based upon an accurate reflection of income. 2. Code Section 382. The Treasury regulations under Code Section 382 are another area of concern. The Clearing House highlights a few specific areas of concern here. Code Section 382 limits the utilization of a corporation s loss carryforwards after one or more shareholders (each holding at least 5% of the stock of the loss corporation) increase their aggregate ownership of the loss corporation by more than 50 percentage points. Therefore, it is necessary to measure the magnitude of the changes in the ownership percentages of such 5% shareholders whenever certain corporate restructurings occur, as well as upon each actual transfer of shares. Further, in certain situations, numerous unrelated shareholders, each owning less than 5% of the loss corporation s stock, are required to be grouped together and treated as a single 5% shareholder whose aggregate ownership percentage must be measured and tracked (a Public Group ). For example, under the existing temporary regulations under Code Section 382, whenever a loss corporation acquires its own stock in exchange for property 15 LMSB (March 17, 2010).

6 The Honorable Douglas H. Shulman 6 February 1, 2011 (a redemption type transaction ) 16, all the less than 5% shareholders whose shares are not redeemed are segregated into a new Public Group whose ownership interest increases as a result of the redemption; this new Public Group must thereafter be treated as a separate Public Group whose percentage ownership must be tracked separately from all other Public Groups. If the loss corporation engages in another redemption type transaction, a second new Public Group is created, whose ownership interest must be tracked, and so on. This redemption rule can be excessively burdensome for loss corporations to administer because, after each repurchase date, a new continuing Public Group is formed which must be separately tracked during the following three year testing period. This creation and tracking of numerous Public Groups in this way does not seem necessary to protect against the loss trafficking that Code Section 382 is aimed at. 17 Recently, in Notice , Treasury and the IRS requested input on a more purposive approach to Code Section 382 so that increases in direct ownership by small shareholders (i.e., less than 5% shareholders) do not create shifts in ownership except in abusive situations. Our suggestions here are in response to that request. To alleviate the tracking burden described above, the regulations could be modified in a way that preserves both their policy intent and the necessary safeguards. For example, all nonredeeming shareholders who are less than 5% shareholders could be treated as members of the loss corporation s existing Public Group. Notice suggests this approach in Example (2) as the expansive application of the Purposive Approach. We agree with this because a redemption of shares from small shareholders each of which is not a 5% shareholder should not be treated as giving rise to an ownership increase for Code Section 382 purposes because it does not create any opportunity to orchestrate future infusions of income generating assets for the purpose of loss trafficking. While The Clearing House acknowledges and agrees with the IRS that the complete adoption of a purposive approach would require major changes to the current regulations, we would welcome the opportunity to work closely with the IRS in identifying particular fact patterns that do not involve the potential for abuse of Code Section 382 to which the purposive approach of Notice could be applied. Finally, we note that reform measures enacted as part of Dodd Frank and Basel III proposals may result in creation of new financial instruments that may raise additional issues under Code Section 382 (e.g., contingent capital, bail in debt or other loss absorbing instruments that may apply to large banks). 3. DCLs. The regulations under Code Section 1503(d) with regard to the use of DCLs of dual resident corporations and certain separate units of domestic corporations (together, DRCs ) 16 Treas. Reg T(j)(2)(iii)(C). 17 Notice , 2010 I.R.B. 27, states that one of the primary abuses Code Section 382 seeks to prevent involves an acquisition of loss corporation stock followed by the contribution of income producing assets or the diversion of income producing opportunities to the corporation in order to engage in loss trafficking (i.e., improperly increasing the utilization of carryover losses).

7 The Honorable Douglas H. Shulman 7 February 1, 2011 are unnecessarily complicated. We recognize that the regulations were substantially revised in 2007 with the intent of simplifying them and making them more administrable and workable for the IRS and taxpayers. 18 We believe, however, that they remain overly complicated and overly burdensome for the IRS and taxpayers. In addition, we believe there are certain substantive rules in these regulations which may unduly complicate the banking industry s efforts to restructure businesses to comply with new regulatory and capital requirements; we believe these rules are not necessary to achieve the policy of the DCL statute and should be revised. Below, we highlight two of these rules. As background, if a DRC has a net loss for any year, its entire net loss is treated as a DCL 19 under the regulations. Generally the use of a DRC s DCL against the U.S. tax liability of the DRC s U.S. consolidated group is restricted if there is a possibility of foreign use of such DCL. 20 Under the regulations, a foreign use of a DCL generally occurs if (a) any portion of a deduction or loss taken into account in computing the DCL is made available under the income tax laws of a foreign country to offset or reduce, directly or indirectly, any item that is recognized as income or gain under those foreign laws and (b) that item of income/gain would be considered (under U.S. tax principles) to be an item of income/gain of a foreign corporation or other foreign person. 21 The first rule we highlight is the all or nothing rule. Under the foreign use definition, any foreign use of any portion of the DRC s losses (for example, the use of $1 of loss, when the aggregate losses are $1 million), is a foreign use of the entire DCL (all $1 million). Thus, under the all or nothing rule, the foreign use of that $1 means that the entire $1 million of losses may not be used against the U.S. group s U.S. tax liability. In addition, if a domestic use election was previously made for the $1 million of losses, the use of that $1 requires a recapture of the entire $1 million of DCLs. The regulations contain certain de minimis exceptions, but these are very limited and do not provide adequate protection against de minimis foreign use events, given the all or nothing rule. The second rule is the mandatory combined separate unit rule, which requires a consolidated U.S. group to treat all of its separate DRCs within any single country as one combined DRC for that country for purposes of applying the DCL regulations. 22 The result of See T.D. 9315, I.R.B. 891, as corrected by Ann I.R.B. at Treas. Reg (d) 1(b)(5). The regulations provide that if a DRC incurs a DCL, the consolidated U.S. group generally is not permitted to make use of the loss to offset its income. If there is no possibility of a foreign use of the DCL in any year, and the taxpayer files a statement with its return supporting that conclusion, the taxpayer is permitted to use the loss against its U.S. income tax liability and does not need to be concerned about potential future triggering events. Treas. Reg (d) 6(c). By contrast, if the taxpayer cannot establish that there is no possibility of foreign use of the DCL, the taxpayer can use the DCL to offset its U.S. tax liability provided that a domestic use election (covering the taxable year and the next five succeeding years) is filed. Treas. Reg (d) 6(d). One requirement of making a domestic use election is that the taxpayer agrees to recapture the applicable DCL (with interest) on its tax return for the year in which any of certain specified triggering events occurs. Treas. Reg (d) 6(h). Any foreign use of the DCL at any time during the period covered by the domestic use election, subject to certain narrow exceptions, is a triggering event. Treas. Reg (d) 6(e)(1)(i). 21 Treas. Reg (d) 3(a)(1). 22 Treas. Regs (d) 1(b)(4)(ii).

8 The Honorable Douglas H. Shulman 8 February 1, 2011 this mandatory combined separate unit rule (together with the all or nothing rule) is that if $1 of loss of one DRC is put to a foreign use, the entire consolidated group s DCL for that country is either restricted for the year in which the DCL was incurred or is recaptured if a domestic use election was made for the DCL. The Clearing House believes that the current DCL all or nothing rule, the mandatory combined separate unit rule and the inadequate de minimis exceptions can produce punitive results which seem to go far beyond the intended policy of the DCL statute. We understand and acknowledge that the IRS in 2007 rejected a suggested narrowing of the all or nothing rule, out of a concern that it would add significant administrative burdens for the Commissioner and taxpayers. 23 However, the same regulations explicitly authorize the IRS to expand the foreign use exceptions through subsequent IRS guidance, 24 and the preamble requested comments on additional situations that should be added to the safe harbors pursuant to this grant of authority. In view of the recent enactment of Dodd Frank regulatory reform as well as recently announced proposals to significantly change capital and liquidity standards for large banks under Basel III, we respectfully request that the IRS take this opportunity to revisit this issue at this time. We believe that the rules can and should be updated so that large commercial banks can restructure their operations in order to more efficiently comply with these new regulatory rules without the risk of triggering negative DCL tax consequences. One possibility would be to modify or expand the existing de minimis exceptions to afford better protection against these unnecessarily harsh results. Another helpful modification would be to allow taxpayers to elect out of the mandatory combined separate unit rule on a retroactive basis. 4. Section 956 and Swaps. The Clearing House also is concerned that the practice of clearing swaps through regulated central clearinghouses may create unintended tax consequences under Code Section 956. Dodd Frank generally requires clearing of swaps through regulated clearinghouses. These clearinghouses are often organized as U.S. entities that may be treated as partnerships for U.S. tax purposes, with U.S. financial institutions typically holding limited partnership (or similar) ownership interests. Swaps often require an upfront payment to be made by one of the counterparties. For example, a swap with standardized terms may require an upfront payment to reflect the present value of the difference between the swap s standardized coupon rate and current market rates over the stated term of the swap. Swaps without standardized terms often have T.D. 9315, I.R.B. 891, as corrected by Ann I.R.B. at Treas. Reg (d) 3(c)(9); T.D. 9315, I.R.B. 891, as corrected by Ann I.R.B. at 1300.

9 The Honorable Douglas H. Shulman 9 February 1, 2011 upfront payments for good business reasons (for example, to match an obligation of one party that is being hedged by the swap). The question arises as to the appropriate treatment under Code Section 956 of a swap with an upfront payment that is cleared through a U.S. clearinghouse by a controlled foreign corporation (a CFC ) whose U.S. shareholder holds a partnership interest in the clearinghouse. Increasingly, foreign subsidiaries of U.S. financial institutions are using U.S. clearinghouses to clear the swaps they have entered into with foreign counterparties. 25 Code Section 956 provides generally that a U.S. shareholder of a CFC is subject to U.S. tax on a current basis on the amount of any investment made by the CFC in U.S. property. 26 The law generally characterizes these investments as distributions of the CFC s earnings to the U.S. shareholder and taxes them as Subpart F income (subject to certain exceptions). A loan from a CFC to a U.S. partnership would be treated as an investment by the CFC in U.S. property if one of the partners in the partnership is a U.S. affiliate of the CFC (regardless of the size of the partner s ownership interest in the partnership). Pursuant to the Treasury regulations under Code Section 446, a NPC that qualifies as a swap with a significant nonperiodic payment is treated as two separate transactions consisting of an on market, level payment swap and a loan. 27 We believe that a CFC that enters into a swap with an upfront payment (where the swap is an NPC subject to the rules described above), should not be treated as having made a Section 956 investment in U.S. property merely by virtue of the CFC clearing the swap through a U.S. clearinghouse in which a U.S. affiliate is a member. In our view, the economics of this situation in no way involve a flow of funds from the CFC to the U.S. shareholder (and thus it is inappropriate to treat this as a deemed loan to the U.S. shareholder). As an initial matter, ownership in U.S. clearinghouses generally is limited to a small minority stake. Further, and more importantly, the payment made to the U.S. clearinghouse generally will be matched by an equivalent payment by the clearinghouse to a third party in a corresponding back to back trade. Moreover, often this upfront payment must be posted back as initial collateral on the transaction. In summary, there is no net lending of funds from the CFC to the U.S. shareholder or an affiliate, and amounts should not be treated as Subpart F income. Absent favorable clarification of this issue, which we believe is well within the IRS s authority, foreign financial institutions with U.S. owners could be discouraged from clearing foreign executed swaps through U.S. clearinghouses. ***** 25 This question also arises when a foreign subsidiary (that is a broker/dealer) clears a trade through its U.S. shareholder (or a U.S. affiliate) that is a member of a clearinghouse and the U.S. clearinghouse member is acting as a principal in the clearing trade (rather than as an agent for the clearinghouse). 26 Code Sections 956(a), (c)(1)(c). 27 Treas. Reg (g)(4).

10 The Honorable Douglas H. Shulman 10 February 1, 2011 Thank you for considering and giving us the opportunity to share our views. We would be pleased to discuss these matters further with you and your staff at your convenience. If we can facilitate arranging for those meetings, or if you have any questions or need further information, please do not hesitate to contact me at ( Sincerely yours, David Wagner Senior Vice President, Financial and Tax Affairs cc: Heather Maloy Commissioner, Large Business and International Division Internal Revenue Service Walter Harris Industry Director, Financial Services Large Business and International Division Internal Revenue Service Paul Saltzman President The Clearing House Association L.L.C.