In Revenue Procedure 2017-12, the IRS provides that internal "total loss-absorbing capacity" instruments (TLACs) will be treated as debt for federal tax purposes. The revenue procedure responds to concerns raised by banking regulations requiring banks to issue TLACs in order to absorb losses that would occur if a large financial institution should fail. Certain features of internal TLACs required under the rules issued by the Federal Reserve Board cast doubt on whether internal TLACs generally would be treated as debt for federal income tax purposes.

Background

Banks are subject to special provisions of the Internal Revenue Code and Treasury regulations in addition to comprehensive non-tax regulations that govern their capital structure and their transactions. Non-tax regulators and regulations governing banks include:

1. The Basel Committee on Banking Supervision (Basel), which sets internationally agreed minimum standards for the regulation and supervision of banks

2. The international Financial Stability Board (FSB), which develops regulatory and supervisory policies for financial entities, including banks, and focuses on the type of systemic risk associated with the failure of a large financial institution

The current framework for international bank capital is commonly known as Basel III. One of the goals of Basel III regulators has been to design a new class of security, called TLACs, which would absorb the losses if a bank should fail. In the regulators' view, if losses were to wipe out a firm's capital, a large amount of long-term unsecured debt would provide a mechanism for absorbing additional losses and recapitalizing the firm without spreading the losses throughout the financial system and damaging the economy.

Standards issued by the FSB describe the requirements for an instrument to qualify as a TLAC and require global systemic important banking organizations (GSIBs) to issue an amount of TLACs determined by reference to the bank group's risk-weighted assets and Basel III leverage ratio. According to the standard, external TLACs are securities, in the form of debt, issued to third-party investors by a parent (in general), while internal TLACs are securities issued by a subsidiary to a parent. The FSB standards generally require a foreign GSIB operating in the US to establish a domestic intermediate holding company (IHC) to hold its US subsidiaries. The IHC would be required to issue internal TLACs to the foreign GSIB.

Under the FSB rules, TLACs (both internal and external) must: (i) have a maturity of at least one year, (ii) be callable prior to maturity only with regulatory approval, (iii) be unsecured, and (iv) generally be subordinate to insured deposits, other short-term deposits, derivatives, structured notes, non-contractual liabilities like tax liabilities, and secured liabilities.

TLACs may rank senior to certain securities that can qualify for equity credit under Basel III, but generally must be subordinate to a bank's depositors and general creditors. The FSB standard also calls for TLACs to contain a contractual trigger or be subject to a statutory mechanism that permits the regulator to write the TLACs down or convert TLACs to equity in certain conditions.

Federal Reserve Board regulations on TLACs

The Federal Reserve Bank (the Fed) issued final regulations in December 2016 that prescribe the amount and form of both external and internal TLACs required for domestic GSIBs and the US operations of foreign GSIBs. In the case of internal TLACs, the Fed regulations require the domestic IHC of a foreign GSIB to issue a specified minimum amount of TLACs to its foreign parent. These rules provide that the internal TLACs must:

(i) Be unsecured and cannot be guaranteed by the IHC or a subsidiary of the IHC, and generally cannot be subordinated to any other arrangement

(ii) Have a maturity of at least one year from the date of issuance

(iii) Be governed by the laws of the United States or any State thereof

(iv) Not provide the holders of the TLACs with a right to accelerate payment, except in the event of: (A) a receivership, insolvency, liquidation, or similar proceeding of the IHC; or (B) a default by the IHC that continues for 30 days or more

(v) Be issued to and held by a foreign financial institution that directly or indirectly controls the IHC or is a wholly owned subsidiary of such company

(vi) Have a contractual provision that allows for an internal debt conversion order (an order by the Fed to immediately convert or exchange the instrument to common equity)

An internal debt conversion order may be issued if the IHC is in default or danger of default and any of three enumerated circumstances apply. Additional technical rules that apply to the TLACs are set forth in12 CFR Section 252.163(a) and (b).

Although TLACs are issued in the form of debt, they may have features that are not consistent with indebtedness for federal tax purposes. For federal tax purposes, an instrument that does not unconditionally obligate the issuer to pay a sum certain on demand or at one or more fixed dates, or that does not provide the holder with the rights of a creditor, generally is not treated as debt. Accordingly, whether internal TLACs issued under the Fed rules would constitute indebtedness for federal tax purposes under general common law principles is uncertain.

Revenue Procedure 2017-12

Revenue Procedure 2017-12 treats internal TLACs issued by an IHC under the rules established by the Fed as indebtedness for federal tax purposes to the extent that the internal TLACs have not been subject to a debt conversion order. The rule applies to debt issued on or after December 15, 2016.

Implications

Foreign "big banks" have been asking for this guidance due to concerns about large loans made to their US subsidiaries that would be required under the Fed's internal TLAC proposal. Tax advisers had significant doubts as to whether those loans would be treated as debt for federal tax purposes. Revenue Procedure 2017-12 was unsurprising as the final Section 385 regulations had alluded to it. Nonetheless, Revenue Procedure 2017-12 is welcome news to the banking community and should allow IHCs to structure their internal TLACs in a tax-efficient manner. The choice of a revenue procedure rather than a revenue ruling to provide this guidance suggests that the Service views this guidance as an exception to the common law tax determination of what constitutes debt for tax purposes and underscores the risk of trying to draw any inferences from this guidance for any instrument that is not specifically covered.

One aspect of the revenue procedure that may need further clarification is whether Revenue Procedure 2017-12 applies only to the minimum amount of internal TLACs required under the Fed's rules. It is unclear whether the cross-reference in section 3 of the Revenue Procedure to the issuance of internal TLACs described in section 2.04 of the Revenue Procedure is limited to the minimum amount required under the Fed's rules.

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