Tax Issues Faced by Financial Institutions

International Fiscal Association USA Branch Young IFA Network Summer Seminar Wednesday, August 2, 2017 Tax Issues Faced by Financial Institutions Emily Fett Senior Manager EY, LLP Jonas Robison Managing Associate Orrick, Herrington & Sutcliffe Daniel Simon Partner PwC, LLP

Overview Final Section 987 Regulations What Should Taxpayers Do Pre-Transition? What Should Taxpayers Do Post-Transition? Dodd Frank Margin Rules & Section 871(m) Developments Scope and Implementation Section 871(m) Developments Intermediate Holding Company Rules under Dodd Frank Overview of the Intermediate Holding Company Rules Changing Repo Markets and Shifting of Business Strategic Joint Ventures 2

SECTION 987 REGULATIONS 3

Overview: Section 987 Regulations Final section 987 regulations published on 12/7/2016 provide guidance for determining taxable income or loss (or E&P) with respect to certain branch operations that use a different functional currency than their owner ( 987 QBU ) Provide rules for timing, amount, character, and source of section 987 gain or loss using the foreign exchange exposure pool ( FEEP ) method Impute section 987 gains and losses only to marked items (generally monetary assets and liabilities) Do not apply to certain financial institutions Generally effective beginning 1/1/2018 for calendar year taxpayers, but taxpayers can apply to taxable years beginning after 12/7/2016 Must be applied consistently to all 987 QBUs of the taxpayer Mandatory fresh start transition method and temporary deferral rules may eliminate previously unrecognized section 987 gains and losses determined under prior methodologies 4

What Should Taxpayers Do Immediately? Identify all material 987 QBUs Validate U.S. tax functional currency for each QBU Confirm current section 987 methodology for each QBU Determine amount of unrecognized section 987 gain or loss under current methodology Identify relevant tax attributes, such as E&P and subpart F incomegenerating assets Assess ability to make, and treatment of, remittances and terminations prior to 12/31/2017, including the effect of section 987 loss deferral rules Identify all material unrealized section 988 gains and losses and consider applicability of loss deferral rules Determine whether to apply the final section 987 regulations early 5

What Should Taxpayers Do Pre-Transition? Determine which 987 QBUs will be subject to the final regulations Determine which assets and liabilities will be attributed to 987 QBUs Prepare summary organization chart of 987 QBUs (may differ from legal structure) Gather data necessary to comply with, and transition to, the final regulations 6

What Should Taxpayers Do Upon Transition? Apply the fresh start transition rules of Treas. Reg. 1.987-10 Terminate all 987 QBUs subject to the final regulations the day prior to transition Establish opening balance sheet for each 987 QBU Determine any adjustments under Treas. Reg. 1.987-10(d) Gather information needed for tax return related to transition Determine/validate reasonable method for branch operations not subject to final regulations, including nonaggregate partnerships 7

MARGIN RULES UNDER DODD FRANK AND 871(M) IMPLEMENTATION 8

Dodd-Frank Margin Rules / 871(m) This Discussion will Address Recent Developments in: 1) Implementation and cross-border application of uncleared swap margin rules under Dodd-Frank. 2) Implementation of Section 871(m) regulations. 9

Uncleared Swap Margin Rules Two Sets of Rules: Prudential Regulators o o CFTC o The OCC, Federal Reserve, FDIC, FCA, and FHFA Rules applicable to banks Rules applicable to non-banks The Two Rules are Closely Similar, with Certain Exceptions 10

Uncleared Swap Margin Rules Applicability: The rules apply only to uncleared swaps entered into by one or more swap dealers or major swap participants (collectively, CSEs ). General Margin Rule: CSEs must post or collect (as applicable) initial margin (IM) and variation margin (VM) daily during the entire tenor of an uncleared swap. Applicability of IM and VM Rules (CSE collection and posting): Counterparty Initial Margin Variation Margin CSE Y Y Financial End-User with Material Swaps Exposure Y Y Financial End-User without Material Swaps Exposure N Y Others (e.g., Non-Financial End-Users) N N 11

Uncleared Swap Margin Rules Exemption of Certain End-Users Conditions: Using uncleared swaps to hedge commercial risk; and Qualifying end-user: o o o o Financial institutions (small banks, savings associations, Farm Credit System institutions, credit unions) having total assets of US$10 billion or less; Certain financial cooperatives hedging risk associated with originating loans for their members; Commercial end-user (including treasury affiliates that are not financial endusers and are acting as agents); Qualifying captive finance companies. 12

Uncleared Swap Margin Rules Initial Margin Applicability (i.e., a CSE must collect from and post to, on a daily basis): a. CSEs b. Financial End-Users with Major Swaps Exposure i. Financial End-User: bank holding companies, depository institutions, foreign banks, federal / state credit unions, entities regulated by the FHFA, registered investment companies, commodity pools, employee benefit plans, brokers / dealers, certain private funds, mortgage-related funds and ABS issuers, insurance companies, etc. ii. Material Swaps Exposure (subject to certain adjustments): the entity and its affiliates have an average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, FX forwards and FX swaps with all counterparties for June, July and August of the previous calendar year in excess of $8 billion. 13

Uncleared Swap Margin Rules Initial Margin, cont. Collecting and Posting: IM Calculated Amount minus IM Threshold Amount a. IM Calculated Amount: i. Standardized Initial Margin Schedule (Rule 23.154(c): percentage of notional amount depending on swap asset class and duration) ii. Approved Proprietary IM Model (i.e., internal model approved by CFTC or NFA) b. IM Threshold Amount: US$50 million resulting from all uncleared swaps between the CSE (and its margin affiliates) and the counterparty (and its margin affiliates) 14

Uncleared Swap Margin Rules Variation Margin Applicability (i.e., CSE must collect from and post to, on a daily basis): a. CSEs b. Financial End-Users with Material Swaps Exposure c. Financial End-Users without Material Swaps Exposure 15

Uncleared Swap Margin Rules Variation Margin, cont. VM is defined as collateral provided by a party to its counterparty to meet the performance of its obligations under one or more uncleared swaps between the parties as a result of a change in value of such obligations since the trade was executed or the last time such collateral was provided. (Essentially, a change in mark-to-market value.) CSE are permitted to calculate VM on an aggregate basis across all uncleared swaps executed under a single Eligible Master Netting Agreement (or a separate netting portfolio thereunder). 16

Uncleared Swap Margin Rules Eligible Collateral Variation Margin i. to or from a CSE cash only ii. to or from a Financial End-User cash and non-cash eligible to satisfy IM requirements Initial Margin (subject to specified haircuts): cash denominated in a major currency or currency of settlement of a swap; securities issued or guaranteed by a U.S. government agency, the ECB or certain sovereign entities; certain debt securities issued by and ABS guaranteed by, GSEs; certain redeemable securities in pooled investment funds that invest in U.S. government securities or securities issued by the ECB or certain sovereign entities; certain corporate debt securities; securities issued or guaranteed by the BIS, IMF or a multilateral development bank (e.g., IBRD, EBRD, EIB); certain listed equities; and gold. 17

Uncleared Swap Margin Rules Compliance Dates Phase-in Compliance Schedule determined by calculating the average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, FX forward and FX swaps for each business day of March, April and May for both parties and their respective margin affiliates. *The regulators indicated in early 2017 that market participants generally may comply by September 1, 2017 rather than the March 1, 2017 VM compliance date shown above. 18

Uncleared Swap Margin Rules Cross-Border Application The CFTC rules do not apply to a swap between a non-u.s. CSE and non- U.S. person counterparty, if (i) neither counterparty is a Foreign Consolidated Subsidiary or a U.S. branch of a non-u.s. CSE and (ii) neither counterparty s obligations under the relevant swap are guaranteed by a U.S. person. U.S. person is defined as, among other things: o o o An individual resident of the United States or legal entity organized in United States, including any branch of such legal entity; A legal entity that has its principal place of business in the United States; or A legal entity owned by one or more U.S. persons and for which such persons bear unlimited responsibility for the obligations and liabilities of the legal entity. 19

Uncleared Swap Margin Rules A Foreign Consolidated Subsidiary means a non-u.s. CSE whose financial statements are included in those of a U.S. ultimate parent entity. Guarantee means an arrangement pursuant to which a party has rights of recourse against a guarantor with respect to the counterparty s obligations under the relevant swap transaction. The terms of the guarantee need not be included within the swap documentation. Guarantee also encompasses any arrangement pursuant to which the guarantor itself has rights of recourse against a third party with respect to the counterparty s obligations under the uncleared swap. Various tax implications of moving hedging entity offshore; e.g., a partnership, if continued, should not result in a taxable event, but if terminated, may result in gain recognition. 20

871(m) developments Background Certain payments on equity derivatives with respect to securities that produce U.S.-source dividend income will be treated as U.S. source dividends. Applies to dividend equivalent payments made on simple contracts with a delta equal to or greater than 0.8 or to complex contracts that fail a substantial equivalence test. 21

871(m) developments Definitions A simple contract has (i) a single, fixed number of shares of the underlying security and (ii) a single exercise or maturity date. A complex contract is any contract that is not a simple contract. Delta Test Delta is the ratio of the change in the fair market value of the derivative to a small change in the fair market value of the number of underlying reference shares. Test works well, for example, for vanilla calls and puts. E.g., for a long call, delta increases from 0 to 1. Delta roughly corresponds to probability of the derivative expiring in-themoney. 22

871(m) developments Problems with the Delta Test for Complex Instruments Complex structures have features that make it impossible to determine the number of underlying reference shares : o o E.g., a structured note with 100% downside and 200% upside on the underlying should the denominator be 1 or 2? Barrier options or structured notes knock-in / knock-out features. In such cases, the substantial equivalence test should be used. The substantial equivalence test is much more complicated than delta, but works for any instrument. If an instrument is substantially equivalent to a long position in the underlying equity, it is subject to 871(m). 23

871(m) developments Compliance Dates Pursuant to Notice 2016-76, 871(m) implementation with respect to non-delta one transactions is postponed until January 1, 2018. 871(m) is currently effective with respect delta one transaction issued on or after January 1, 2017. Recent Developments Issuers are currently providing disclosure that a transaction is not delta one. Application of the delta one standard for complex contracts is unclear. Most issuers use the substantial equivalence test for complex contracts. Will the Trump administration modify the final regulations because of their complexity? 24

INTERMEDIATE HOLDING COMPANY RULES UNDER DODD FRANK 25

Pre-TLAC Baseline: Symmetrical treatment of capital stack for book and tax Debt FP Equity Intermediate Holding Company ( IHC ) rules under Dodd Frank s165 subjected FBOs ( foreign banking organizations ) to, amongst other things, U.S. Basel III, capital restrictions, Dodd-Frank stress testing Incremental capital requirements in the US increased overall cost of capital and dilution of after-tax US profits US Branch 900 Debt IHC (US) 100 Equity Limited the ability to lever U.S. operations and align U.S. funding requirements with head office capital stack Impacted FBOs with $5obn in U.S. nonbranch/agency assets; so continued U.S. growth could expand the number of FBOs subject to the DF s165 IHC rules Broker Dealer US Subs Does it go away or diminish? Uncertainty on rule applicability with President-elect Trump s statement to repeal Dodd-Frank Is the rule scope expanded? European Commission rules affecting US outbounds into Europe; is there potential US retaliation and widening of scope? 26

Pre-TLAC Baseline: Ability to create tax deductible equity for some jurisdictions Debt FP Equity The regulatory requirements for equity treatment make it extremely difficult to create a hybrid instrument that is equity for regulatory purposes but debt for U.S. tax purposes US Branch US regulatory group US tax group Non-US US IHC US CO 100 Equity / 900 Debt 50 Equity / 950 Debt Hybrid entities can be used to create tax deductible equity and lever the U.S. tax group in a manner that reflects the home company capital stack This is limited to certain jurisdictions where either LLC s are treated as transparent for foreign tax purposes or other structuring actions are taken This generally split the IHC universe into two separate groups and helped reduce after-tax costs associated with IHC capital requirements for those FBOs who pursued hybrid structures Broker Dealer US Subs 27

and then there was TLAC: Asymmetrical treatment of capital stack for book and tax going against the FBO Debt FP Equity Total Loss Absorbing Capacity ( TLAC ) rules imposed a minimum internal Long Term Debt ( LTD ) requirement for IHCs Essentially, the LTD requirement was the focus of the rule and enhanced resiliency and resolvability of a G-SIB BHC or IHC US Branch Debt 900 (book) / 800 (tax) Equity 100 (book) / 200 (tax) This rule disproportionately impacted FBOs because a key difference compared to domestic BHCs ( Bank Holding Company ) is that internal TLAC must be issued to a foreign parent entity of the IHC IHC (US) This requirement is designed to ensure losses at the IHC can be pushed up to the foreign parent of the IHC Broker Dealer US Subs Subsequent changes did mute the impact Pushing down the cost of TLAC within the US group can be a trap for the unwary 28

Changing Repo Markets and Shifting of Business Current model for funding $US from non-us counterparts US 3 rd Party $/Securities Securities/$ US Broker Dealer $/Securities Securities/$ Foreign Parent $/Securities Securities/$ Non-US 3 rd Party Desired future state for funding $US from non-us counterparts US 3 rd Party $/Securities Foreign Parent $/Securities Non-US 3 rd Party Securities/$ Securities/$ Current model grosses up multiple balance sheets and creates inefficiencies for regulatory capital Back-to-back arrangements increase legal documentation and raise transfer pricing questions Future state is more efficient across trading and regulatory capital requirements. However, there are significant hurdles to achieving the end state model Back office systems work and clearing memberships to be eligible for tri-party Compliance and Legal issues for a foreign entity to engage US counterparts directly 29

Changing Repo Markets and Shifting of Business cont d Current model for funding $US from non-us counterparts US 3 rd Party $/Securities US Broker Dealer $/Securities Securities/$ Securities/$ Potential future state for funding $US from non-us counterparts Foreign Parent $/Securities Securities/$ Non-US 3 rd Party US 3 rd Party $/Securities Foreign Parent $/Securities Non-US 3 rd Party Securities/$ Securities/$ What does this all mean for U.S. tax? Potential large decrease in taxable income (specifically interest income) at the U.S. broker dealer. Are there legacy NOLs or 163(j) issues? Impacts on 882-5 Calc at US tax Branch? Are there 0pportunities away from FP? For example, consider non-us based sales & trading, don t book in US and shift this income away from the US branch 30

Strategic Joint Ventures Certain bank assets have become prohibitively expensive under new Basel rules, e.g., corporate loan books carry large RWA and LBS values Example 1 FP Banks looking to keep relationships and participate out the loans in a manner that reduces the reg cap carry costs There are numerous US tax considerations related to participations depending on the type of loans included 3 rd Party US Corporate $US Loan US Branch Participation 3 rd Party New Model Treaty rules may make it more difficult to mitigate ECI risk and limit investor base for these structures In addition to loan books, certain prime services or flow trading businesses are not producing attractive returns for banks Example 2 FP Third party investors may be looking for investment opportunities and access to these otherwise regulated businesses 3 rd Party Investors US Branch US B/D Nature of the investment structure has numerous knock on tax issues, both US and cross-border considerations JV SPE Synthetic transfer of specific US business 31