August 1, 2010 Financial reform act has significant tax implications for certain financial institutions While the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"), signed by President Obama into law on July 21, 2010, contains few explicit tax sections, the regulatory reform provisions may have significant tax implications for affected financial institutions. (For detailed discussion of the Act's key provisions, see Tax Alert 2010-966.) To assist companies in implementing the Act's requirements, this Alert outlines some of the tax implications of the Act's key provisions. "Volcker Rule" The Act generally prohibits banks from engaging in trading and investing in hedge funds and private equity funds other than during the first year of a new fund. Exceptions to this rule, known as "the Volcker rule," include (1) de minimis investments in hedge funds and private equity funds of no more than 3% of a bank's Tier 1 capital in all such funds combined and 3% of any one fund's total ownership interest; (2) trading in certain government securities, and trading in connection with an underwriting, as part of market-making activities, on behalf of customers or as part of risk-mitigating hedging activities; and (3) offshore trading activities conducted by entities not controlled by a U.S. bank. (For a more detailed discussion on the Volcker rule, see the Attachment below.) A separate provision modifying the Volcker rule generally prohibits underwriters or sponsors of asset-backed securities from engaging in any transaction, such as shorting the securities, that would result in a material conflict of interest with investors in that security for one year. The provision does, however, permit hedging. Complying with these requirements will significantly constrain transactions and relationships among a fund advised by a bank, or an affiliate of the company and any entity within the group. Many banks may need to spin off parts of their operations or otherwise dispose of their interests in their trading portfolios and private equity and hedge fund businesses. As these actions have significant tax consequences, companies need to consult with their tax departments and tax advisors to ensure that the actions undertaken are as tax-efficient as possible. Banks must comply with these prohibitions by the earlier of one year after the completion of a study and issuance of regulations, or July 21, 2012, after which there is a two-year transition period. There is the possibility of applying for additional extensions of time. Capital Requirements To meet their capital requirements, financial institutions have used, in part, trust preferred securities, which are hybrid securities, treated as Tier 1 capital for regulatory purposes, but as debt for US tax purposes. The Act phases out their treatment as Tier 1 capital over three years, beginning January 1, 2013, for holding companies with assets of $15 billion or more. In addition, the Act requires bank regulators to prepare a formal study, with recommendations due back in two years, to determine whether certain systemically significant financial institutions should be required to issue so-called contingent capital securities. Globally, the use of contingent capital securities is still in its infancy stage, as only a few foreign banks have used them over the past year or two. While certain European countries treat these securities for tax purposes similar to how the United States currently treats trust preferred securities, it is questionable whether contingent capital securities, as currently structured in Europe, would be considered debt for US tax purposes. Although the utilization of contingent capital securities requires a formal study during the next two years, the phase-out of trust preferred securities means the financial institutions may be losing a tax-efficient form of raising capital. Unless trust preferred securities are replaced with another hybrid-type security that qualifies as debt financing for US tax purposes, financial institutions potentially face a tax increase as a result of the Act. OTC Derivatives The Act, which generally requires most swap contracts to be centrally cleared and/or exchange-traded, explicitly excludes (for tax years beginning after July 21, 2010), any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement from the definition of a Section 1256 contract. The exclusion was needed because the Act makes several changes to the treatment of such financial instruments that may have otherwise subjected those instruments to Section 1256 mark-to-market and 60/40 long-term/short-term capital gain or loss treatment. This could have significantly affected the timing and character of any gain or loss from these contracts for non-dealers or non-electing traders. This could have also precluded dealers and electing traders from treating these contracts as Section 475 securities (which already requires gains or loss to be marked-to-market), significantly affecting the character of any gain or loss from these contracts. As the Act confirms that gains or losses from these swaps are not subjected to the rules under Section 1256, taxpayers will be allowed to apply the same tax treatment for these swaps as before the enactment of the Act, even if these swaps are now exchange traded. Accordingly, instruments that, prior to the Act, were not required to be marked-to-market will continue to avoid mark-to-market treatment. The mandatory clearing and exchange trading of most swaps would generally require that most swaps will now have "standardized" terms and conditions in order to facilitate clearing and exchange-trading. The trading of swaps with standardized terms could lead to more swaps requiring upfront or other nonperiodic payments. The tax treatment of nonperiodic payments could have significant tax consequences with respect to how companies account for these payments for income tax purposes. Nonperiodic payments could also cause swaps to be treated as having embedded loans, which could also have significant tax consequences with respect to properly accounting for and reporting any interest components, as well as potential withholding tax or subpart F consequences. Standardized terms could also affect a taxpayer's ability to properly utilize some of the hedge integration rules under the Internal Revenue Code and regulations. Companies need to consult with their tax departments and tax advisors to ensure that the potential tax consequences of nonperiodic payments are addressed, which could include designing and developing a process for analyzing, capturing, and reporting any upfront or other nonperiodic payments. Current integration identifications should also be reviewed and analyzed to determine what potential effects, if any, may occur due to the use of swaps with standardized terms. The Act also restricts banks' ability to engage in certain swaps or similar agreements. As a result, some banks will need to restructure their operations to separate those swap activities, which could have significant tax consequences. For example, taxpayers that rely on certain mark-to-market, hedging, and/or integration rules for tax purposes will need to analyze the effect of any restructuring on their ability to properly utilize these rules if the hedges and associated assets or liabilities are required to be in separate entities. Inbound taxpayers that are engaged in proprietary swaps trading in reliance on the trading safe harbor may also need to monitor the effect of any restructuring to the extent that any new swaps vehicle will engage in both dealer and proprietary swaps trading. In addition, it may be important to determine whether these new swap entities qualify under the different rules that apply to "dealers" in swaps (including the ability to assign or modify swaps without triggering tax consequences). To mitigate those consequences, the tax department and tax advisors need to be involved in both the planning and execution of any restructuring (similar to the "Volcker rule" described earlier). Finally, because the IRS knows many companies engage in these swaps, their use could subject companies to increased audit scrutiny. Recovery & Resolution Planning ("Living Wills") The Act requires certain financial institutions (nonbank financial companies supervised by the Fed and Bank Holding Companies with total consolidated assets equal to or greater than $50 billion) to develop a "living will" that outlines how they will wind down their business if faced with severe financial distress or failure. As legal entity rationalization will be a major component of these recovery plans, to ensure the business's resolution occurs in the most tax-efficient manner possible, companies should consider the following issues when developing their "living wills": Debt Restructuring
Repatriation
Legal Entity Divesture
Other Asset Dispositions
Considering these issues during the planning stage of a "living will" should enable companies to identify and remedy or mitigate issues that may not be fixable when the business is financially distressed or failing. After drafting a "living will," companies should review them periodically (as companies will have to submit their plans on an annual basis to the Fed and FDIC who have the authority to require changes), to ensure they continue to address the tax issues most relevant to the current state of their business. New Assessments on Financial Institutions While law makers ultimately decided not to include a bank tax proposal in the final legislation, the Act does require financial regulators to impose several different assessments on banks and other financial institutions. These assessments offset the increased cost of the government's new responsibilities under the Act. The special assessments imposed under the Act include:
While it is not explicitly stated, these assessments should be tax-deductible, as it does not appear that they are considered fines or penalties or are otherwise an income tax. Financial institutions should continue to monitor the status of the bank levy, as it could still be enacted in future legislation. Incentive Compensation The Act tasks federal regulators with issuing guidance nine months after enactment that requires certain financial institutions to report how their incentive compensation plans are structured. The guidance must also prohibit those institutions from offering incentive compensation plans that encourage "inappropriate risks" that may jeopardize the financial health of the organization. To avoid violating the prohibition on inappropriate risk taking, companies will need to examine their incentive compensation plans and assess whether they encourage recipients to take inappropriate risks. If they do, companies will need to modify their plans to comply with the new guidance. Many financial institutions are currently subject to recently released Final Guidance on Sound Incentive Compensation Policies, which addresses the interplay between compensation and risk. (For a discussion of that guidance, see Tax Alert 2010-964.) Other changes in the Act that will affect executive compensation practices applicable to financial institutions and other public companies include:
Surplus Lines Insurance Companies The Act provides that a policyholder's home state will gain the sole tax collection and regulatory authority over multistate insurance policies in the non-admitted (surplus lines) insurance and reinsurance markets. The provision has been welcomed by the insurance industry because of expectations that it will improve the efficiency of the non-admitted, or surplus lines, insurance market. Proponents of the change also say it will make property and liability insurance more readily available to consumers. Under current law, most states require payment of an allocated portion of tax on multistate risks, but several state statutes impose the tax on the entire gross premium of a multistate risk, creating a "double tax" on a portion of the premium in some transactions. The provision in the Act would prevent such double taxation by providing that the policyholder's home state would have the sole tax collection and regulatory authority over such policies. Conclusion While not entirely tax-focused, the Act may have significant tax implications for companies that must comply with its provisions. Failure to consider these implications could effectively increase the cost of complying. Accordingly, companies should include their tax departments and tax advisors in their discussions about how to comply with the new law to ensure that companies are implementing the provisions in a tax-efficient manner. ——————————————— Positioning for change: A roadmap for implementing US financial reform
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