INSTITTUTE OF INTERNATIONAL BANKERS SEMINAR ON THE U.S. TAXATION OF INTERNATIONAL BANKS JUNE 14, 2011 LEGISLATIVE AND REGULATORY DEVELOPMENTS: TAX IMPLICATIONS OF CERTAIN DODD-FRANK ACT PROVISIONS Richard Coffman Institute of International Bankers Erika Nijenhuis Cleary Gottlieb Steen & Hamilton LLP
The discussion will focus on the following provisions of the Dodd-Frank Act that have or could have tax ramifications: Regulation of the OTC derivatives market, and specifically: swap dealer registration requirements the swaps push out rule and derivatives clearing and reporting requirements The Volcker rule, which involves proprietary trading restrictions, hedge fund and private equity fund restrictions Financial stability and capital requirements specifically, the Collins Amendment 2
TITLE VII: OTC DERIVATIVES Swap Dealer Registration Impact on Foreign Banking Organizations (FBOs) Swap Dealer : a person who holds itself out as a dealer; make a market in swaps; regularly enters into swaps with counterparties as an ordinary course of business for its own account; or based on its activities, is commonly known in the trade as a dealer or market maker in swaps Status may be limited to a single type/class/category of instruments Required to register with the CFTC (swaps) and SEC (security-based swaps) 3
Registration triggers a host of regulatory requirements Entity level capital, margin (uncleared swaps), financial and operational records, risk management procedures Transaction level business conduct, transaction trading records, position limits/monitoring trading, back office/documentation (e.g., confirms), segregation requirements Extraterritorial reach of Title VII Activities outside the U.S. that have a direct and significant connection with activities in, or effect on, U.S. commerce (CFTC) Activities outside the United States that contravene requirements designed to prevent evasion of U.S. requirements (SEC) 4
Implications for FBOs Central booking entity model (head office) Contact U.S. persons directly or through U.S. entity (branch or affiliate) acting as agent Registration limited to U.S.-facing transactions o Entity level defer to comparable home country requirements o Transaction level CFTC/SEC requirements U.S. affiliate as swap dealer All U.S. requirements apply to the affiliate Head office not affected, regardless of whether it (i) guarantees the affiliate or (ii) enters into hedging transactions with the affiliate 5
Section 716: Swap Dealer Push Out Provisions The prohibition: *N+o Federal assistance may be provided to any swaps entity with respect to any swap, security-based swap or other activity of the swaps entity. Swap entity swap dealer or major swap participant Federal assistance discount window borrowing Exception for insured depository institutions (IDIs) but not uninsured branches/agencies Hedging and other similar risk mitigating activity Interest rate swaps, currency swaps and swaps based on bank eligible reference assets but not uncleared CDS (including those referencing ABS) Consequences conduct swap dealing activities through a registered affiliate 6
Tax Issues Arising from Novation of Swap Portfolios to Affiliates Transaction-related issues 1001 event for customer, as non-assigning party? Possible application of 1.1001-4 Common law Potential consequences For customer, 1001 event may (i) accelerate gain, or (ii) give rise to potentially nondeductible loss, followed by income, and/or (iii) terminate elections, such as integration election Redocumentation of ISDA Schedules (tax reps and documents) Deemed significant upfront payment (= deemed loan) on new swap 7
Tax Issues Arising from Novation of Swap Portfolios to Affiliates Entity-related issues Need to rethink global dealing/permanent establishment/transfer pricing arrangements Trade flows will change Relative locations of customer/sales/trading functions may not change Possible 1.882-5 or 163(j) issues 1.882-5 relevant if US branch treated as borrowing from customers 163(j) relevant if US sub treated as borrowing from customers with Bank guarantee 8
Clearing Requirements Mandatory clearing of swaps through a derivatives clearing organization (DCO) that can be cleared through a DCO (if no DCO will accept such a contract, the regulators are directed to investigate and take specified actions including possibly imposing margin or capital requirements) Swaps submitted by a DCO and approved by the CFTC/SEC Swaps that the CFTC/SEC on their own determine should be cleared Cleared through a DCO that is either registered with the CFTC/SEC or is exempt from registration Carve-out for pre-existing swaps (subject to reporting requirements) End-user exception 9
Tax Issues Arising from Clearing and Trading Requirements Possible application of section 1256 Dodd-Frank Section 1601 amends section 1256 Uncertainty as to scope of section 1256 and scope of amendment Significant upfront payment issues Clearing and related restructurings may increase # of swaps with significant upfront payments or deemed upfront payments Information reporting and withholding infrastructures will need to be modified Uncertainty as to when an upfront payment is significant Effect of various special aspects of clearing, including netting of positions and initial variation margin payments 10
SECTION 619: VOLCKER RULE General Prohibition Proprietary trading Fund-related activity: Acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund. Applies to banking entities broadly IDIs and their holding companies FBOs that are deemed BHCs under the IBA any affiliate or subsidiary of any of the foregoing 11
Permissible activities US Government/Agency securities; state/municipal securities Trading in connection with underwriting/market making activities Customer-related trading Proprietary trading conducted solely outside the United States by a banking entity that is not directly or indirectly controlled by another banking entity organized under U.S. law. Fund-related activities conducted solely outside the United States by a banking entity that is not directly or indirectly controlled by another banking entity organized under U.S. law and such activities do not involve the offer or sale of ownership interests in a hedge fund/private equity fund to a resident of the United States. 12
Permissible SOTUS activities Key: Location of the risk and ultimate mind and management of the activity Proprietary trading So long as the risk and the ultimate mind and management for a trading activity are located overseas, FBOs should be able to trade : in U.S. securities and other assets, and in derivatives with U.S. reference assets; and on U.S. exchanges and/or with U.S. counterparties (including through U.S. agents and brokers). 13
Fund-related activities FBOs should be able to invest in or sponsor non-u.s. Private Funds that (i) invest in U.S. portfolio companies, securities and assets and/or (ii) have a U.S. adviser/subadviser, so long as the FBO complies with the following conditions: The ultimate mind and management for the decision to invest in or sponsor a non-u.s. Private Fund is made outside of the United States; The principal making the investment and holding the risk of the investment or the party serving as sponsor, as applicable, is located outside of the United States; The restriction on marketing ownership interests to U.S. residents is satisfied Apply Reg S definition of U.S. person among other things, this would permit offers and sales to: 14
o All natural persons (including U.S. citizens) residing outside the U.S. would be permitted o Foreign subsidiaries of U.S. companies (provided that the foreign subsidiary was not established for purposes of evading these geographic restrictions). In addition, to relieve banks of the almost impossible task of policing the movements of their investors, offers and sales would be permitted to non-u.s. citizens who are temporarily located in the United States (i.e., on vacation or business travel or in a second home). 15
Tax Issues Arising from Volcker Rule Possible transfers of intangibles or good will when an entire business such as traders and their positions are moved to the bank or out of the bank Proprietary trading within scope of rule may be eligible for 864(b) trading in securities or commodities safe harbor Restructuring of funds or feeder entities 16
SECTION 171: COLLINS AMENDMENT IMPACT ON FBOs U.S. BHC SUBSIDIARIES Banking agencies must prescribe minimum risk-based and leverage capital standards applicable to U.S. BHCs These minimum standards are subject to two floors: May not be less than the generally applicable standards under U.S. PCA requirements applicable to IDIs These generally applicable standards are based on U.S. Basel I May not be quantitatively lower than PCA ratios applicable to IDIs when DFA enacted 17
Effective dates and phase-in provisions Debt or equity instruments issued on or after 5/19/2010 effective as of 5/19/2010 Debt or equity instruments issued prior to 5/19/2010 Excluded from Tier 1 capital over 3-year phase in period, starting 1/1/2013 o Impact on hybrid capital, including trust preferred U.S. intermediate BHC subsidiaries of FBOs that have relied on SR 01-1 (U.S. BHC itself need not be well capitalized if FBO parent FHC is) Effective 7/21/2015 GAO study regarding capital requirements for FBOs U.S. BHC subsidiaries due by 1/21/2012 18
Tax Issues Arising from New Bank Capital Requirements U.S. affiliates must consider possibility of issuing hybrid capital, i.e., tax-deductible capital Unclear whether/what kind of hybrid capital will satisfy debt-for-tax rules Dodd-Frank provides that trust preferreds do not qualify as capital Basel III requirement for mandatory conversion or write-down when issuer becomes non-viable raises question whether instrument unconditionally provides for repayment of principal Basel III requirement for subordination to general creditors is atypical for debt For Tier 1 capital, additional Basel III requirements, including that instrument must be perpetual and interest must be non-cumulative Fed may impose additional requirements. 19