U5 Financial PeIorm Act

has signiIicant tax

implications
While Lhe DoddFrank Wall SLreeL Relorm
and Consumer ProLecLion AcL (Lhe AcL),
siqned by PresidenL Obama inLo law on 21
July 2010, conLains lew expliciL Lax secLions,
Lhe requlaLory relorm provisions may have
siqnilcanL Lax implicaLions lor allecLed
lnancial insLiLuLions. 1o assisL companies in
implemenLinq Lhe AcL's requiremenLs, Lhis
AlerL ouLlines some ol Lhe Lax implicaLions ol
Lhe AcL's key provisions.
1 US FinanciaI Refcrm Act Has Sinificant Tax !mpIicaticns
Capital
requirements
1o meeL Lheir capiLal requiremenLs,
lnancial insLiLuLions have used, in
parL, LrusL prelerred securiLies, which
are hybrid securiLies, LreaLed as 1ier
1 capiLal lor requlaLory purposes, buL
as debL lor US Lax purposes. Because
Conqress did noL view Lhese insLrumenLs
as Lrue core capiLal, Lhe AcL phases ouL
Lheir LreaLmenL as 1ier 1 capiLal over
Lhree years, beqinninq 1 January 2013
lor holdinq companies wiLh asseLs ol
S15 billion or more. ln addiLion, Lhe AcL
requires bank requlaLors Lo prepare a
lormal sLudy, wiLh recommendaLions due
back in Lwo years, Lo deLermine wheLher
cerLain sysLemically siqnilcanL lnancial
insLiLuLions should be required Lo issue
conLinqenL capiLal securiLies.
Clobally, Lhe use ol conLinqenL capiLal
securiLies is sLill in iLs inlancy sLaqe, as
only a lew loreiqn banks have issued
Lhem over Lhe pasL year or Lwo. While
cerLain Luropean counLries LreaL Lhese
securiLies lor Lax purposes similarly
Lo how Lhe US currenLly LreaLs LrusL
prelerred securiLies, iL is quesLionable
wheLher conLinqenL capiLal securiLies, as
currenLly sLrucLured in Lurope, would be
considered debL lor US Lax purposes.
AlLhouqh Lhe uLilizaLion ol conLinqenL
capiLal securiLies requires a lormal
sLudy durinq Lhe nexL Lwo years, Lhe
phase ouL ol LrusL prelerred securiLies
means Lhe lnancial insLiLuLions may
be losinq a LaxellcienL lorm ol raisinq
capiLal. Unless LrusL prelerred securiLies
are replaced wiLh anoLher hybridLype
securiLy LhaL qualiles as debL lnancinq
lor US Lax purposes, lnancial insLiLuLions
poLenLially lace a Lax increase as a resulL
ol Lhe AcL.
Complyinq wiLh Lhese requiremenLs will
siqnilcanLly consLrain LransacLions and
relaLionships amonq a lund advised by
a bank, or an allliaLe ol Lhe company
and any enLiLy wiLhin Lhe qroup. Many
banks may need Lo consider spinninq oll
parLs ol Lheir operaLions or oLherwise
disposinq ol Lheir inLeresLs in Lheir
Lradinq porLlolios and privaLe equiLy and
hedqe lund businesses. As Lhese acLions
would have siqnilcanL Lax consequences,
companies need Lo consulL wiLh Lheir Lax
deparLmenLs and Lax advisors Lo ensure
LhaL Lhe acLions underLaken are as Lax
ellcienL as possible. 1hese prohibiLions
become ellecLive by Lhe earlier ol one
year alLer Lhe compleLion ol a sLudy
and issuance ol requlaLions or 21 July
2012, alLer which Lhere is a Lwoyear
LransiLion period. 1here is Lhe possibiliLy
ol applyinq lor addiLional exLensions
ol Lime.
Volcker Pule
1he AcL qenerally prohibiLs banks lrom
enqaqinq in proprieLary Lradinq and
invesLinq in hedqe lunds and privaLe
equiLy lunds oLher Lhan durinq Lhe lrsL
year ol a new lund. LxcepLions Lo Lhis
rule, known as "Lhe Volcker rule," include
(1) de minimis invesLmenLs in hedqe
lunds and privaLe equiLy lunds ol no
more Lhan 37 ol a bank's 1ier 1 capiLal
in all such lunds combined and 37 ol any
one lund's LoLal ownership inLeresL; (2)
Lradinq in cerLain qovernmenL securiLies,
and Lradinq in connecLion wiLh an
underwriLinq, as parL ol markeLmakinq
acLiviLies, on behall ol cusLomers or as
parL ol riskmiLiqaLinq hedqinq acLiviLies;
and (3) ollshore Lradinq and invesLmenL
acLiviLies conducLed by enLiLies noL
conLrolled by a U.S. bank.
A separaLe provision modilyinq Lhe
Volcker rule qenerally prohibiLs
underwriLers or sponsors ol asseL
backed securiLies lrom enqaqinq in
any LransacLion, such as shorLinq Lhe
securiLies, LhaL would resulL in a maLerial
conlicL ol inLeresL wiLh invesLors in LhaL
securiLy lor one year. 1he provision does,
however, permiL hedqinq.
2 US FinanciaI Refcrm Act Has Sinificant Tax !mpIicaticns
1he AcL also resLricLs Lhe banks' abiliLy
Lo enqaqe in cerLain swaps or similar
aqreemenLs by requirinq Lhese swaps Lo
be LransiLioned Lo separaLely capiLalized
allliaLes. As a resulL, some banks will
need Lo resLrucLure Lheir operaLions Lo
separaLe Lhose swap acLiviLies, which
could have siqnilcanL Lax consequences.
For example, Laxpayers LhaL rely on
cerLain markLomarkeL, hedqinq and/
or inLeqraLion rules lor Lax purposes
will need Lo analyze Lhe ellecL ol any
resLrucLurinq on Lheir abiliLy Lo properly
uLilize Lhese rules il Lhe hedqes and
associaLed asseLs or liabiliLies are
required Lo be in separaLe enLiLies.
lnbound Laxpayers LhaL are enqaqed in
proprieLary swaps Lradinq in reliance on
Lhe Lradinq sale harbor may also need Lo
moniLor Lhe ellecL ol any resLrucLurinq
Lo Lhe exLenL LhaL any new swaps vehicle
will enqaqe in boLh dealer and swaps
Lradinq lor iLs own accounL. ln addiLion, iL
may be imporLanL Lo deLermine wheLher
Lhese new swap enLiLies qualily under
Lhe dillerenL rules LhaL apply Lo "dealers"
in swaps (includinq Lhe abiliLy Lo assiqn
or modily swaps wiLhouL Lriqqerinq Lax
consequences). Finally, a bank's acLiviLies
in proprieLary swaps Lradinq would be
sub|ecL Lo Lhe "Volcker rule" discussed
above. 1o miLiqaLe Lhose consequences,
Lhe Lax deparLmenL and Lax advisors
need Lo be involved in boLh Lhe planninq
and execuLion ol any resLrucLurinq
(similar Lo Lhe Volcker Rule described
earlier). Finally, because Lhe lRS knows
many companies enqaqe in Lhese swaps,
Lheir use could sub|ecL companies Lo
increased audiL scruLiny.
1he mandaLory clearinq and exchanqe
Lradinq ol mosL swaps would qenerally
require LhaL mosL swaps will now have
"sLandardized" Lerms and condiLions
Lo laciliLaLe clearinq and exchanqe
Lradinq. 1he Lradinq ol swaps wiLh
sLandardized Lerms could lead Lo more
swaps requirinq uplronL or oLher non
periodic paymenLs. 1he Lax LreaLmenL
ol nonperiodic paymenLs could have
siqnilcanL Lax consequences wiLh respecL
Lo how companies accounL lor Lhese
paymenLs lor income Lax purposes.
Nonperiodic paymenLs could also cause
swaps Lo be LreaLed as havinq embedded
loans, which could also have siqnilcanL
Lax consequences wiLh respecL Lo
properly accounLinq lor and reporLinq
any inLeresL componenLs, as well as
poLenLial wiLhholdinq Lax or subparL F
consequences. SLandardized Lerms could
also allecL a Laxpayer's abiliLy Lo properly
uLilize some ol Lhe hedqe inLeqraLion
rules under Lhe lnLernal Revenue Code
and requlaLions. Companies need Lo
consulL wiLh Lheir Lax deparLmenLs and
Lax advisors Lo ensure LhaL Lhe poLenLial
Lax consequences ol nonperiodic
paymenLs are addressed, which could
include desiqninq and developinq a
process lor analyzinq, capLurinq and
reporLinq any uplronL or oLher non
periodic paymenLs. CurrenL inLeqraLion
idenLilcaLions should also be reviewed
and analyzed Lo deLermine whaL poLenLial
ellecLs, il any, may occur due Lo Lhe use
ol swaps wiLh sLandardized Lerms.
CTC derivatives
1he AcL, which qenerally requires LhaL
mosL swap conLracLs be cenLrally cleared
and/or exchanqeLraded, expliciLly
]p[dm\]k (lor Lax years beqinninq alLer
21 July 2010), any inLeresL raLe swap,
currency swap, basis swap, inLeresL raLe
cap, inLeresL raLe loor, commodiLy swap,
equiLy swap equiLy index swap, crediL
delaulL swap, or similar aqreemenL lrom
Lhe delniLion ol a SecLion 1256 conLracL.
1he exclusion was needed because
Lhe AcL makes several chanqes Lo Lhe
LreaLmenL ol such lnancial insLrumenLs
LhaL may have oLherwise sub|ecLed Lhose
insLrumenLs Lo SecLion 1256 markLo
markeL and 60/^0 lonqLerm/shorLLerm
capiLal qain or loss LreaLmenL. 1his could
have had a siqnilcanL impacL on Lhe
Liminq and characLer ol any qain or loss
lrom Lhese conLracLs lor nondealers or
nonelecLinq Lraders. 1his could have also
precluded dealers and elecLinq Lraders
lrom LreaLinq Lhese conLracLs as SecLion
^75 securiLies (which already require
qains or losses Lo be markedLomarkeL),
siqnilcanLly allecLinq Lhe characLer ol
any qain or loss lrom Lhese conLracLs.
As Lhe AcL conlrms LhaL qains or losses
lrom Lhese swaps are noL sub|ecLed
Lo Lhe rules under SecLion 1256,
Laxpayers will be allowed Lo apply Lhe
same Lax LreaLmenL lor Lhese swaps as
belore Lhe enacLmenL ol Lhe AcL, even il
Lhese swaps are now exchanqe Lraded.
Accordinqly, insLrumenLs LhaL, prior Lo
Lhe AcL, were noL required Lo be marked
LomarkeL will conLinue Lo avoid markLo
markeL LreaLmenL.
3 US FinanciaI Refcrm Act Has Sinificant Tax !mpIicaticns
New assessments
on hnancial
institutions
While lawmakers ulLimaLely decided noL
Lo include a bank Lax proposal in Lhe lnal
leqislaLion, Lhe AcL does require lnancial
requlaLors Lo impose several dillerenL
assessmenLs on banks and oLher lnancial
insLiLuLions. 1hese assessmenLs are
inLended Lo ollseL Lhe increased cosL ol
Lhe qovernmenL's new responsibiliLies
under Lhe AcL.
1he special assessmenLs imposed under
Lhe AcL include:
AssessmenLs on asseLs Lo lund FDlC
insurance, which apply Lo insLiLuLions
wiLh more Lhan S10 billion in
asseLs, and are based on an insured
deposiLory insLiLuLion's averaqe
consolidaLed LoLal asseLs minus iLs
averaqe Lanqible equiLy, raLher Lhan,
as previously calculaLed, on iLs deposiL
base
A special assessmenL Lo lund Lhe
operaLions ol Lhe new Financial
SLabiliLy OversiqhL Council
(Lhe Council), which applies Lo
"sysLemically imporLanL" lnancial
insLiLuLions, Lo be delned by Lhe
1reasury and Lhe Council
A special assessmenL Lo cover
expanded supervisory responsibiliLies,
which also applies Lo sysLemically
imporLanL lnancial insLiLuLions
An assessmenL on lnancial
insLiLuLions wiLh asseLs ol more Lhan
S50 billion Lo ollseL resoluLion cosLs,
which would apply only il Lhe FDlC
could noL repay lunds borrowed lrom
Lhe 1reasury wiLhin 60 monLhs Lo pay
lor Lhe orderly resoluLion ol larqe
lailed lnancial insLiLuLions
While iL is noL expliciLly sLaLed, Lhese
assessmenLs should be LaxdeducLible,
as iL does noL appear LhaL Lhey are
considered lnes or penalLies or are
oLherwise an income Lax. Financial
insLiLuLions should conLinue Lo moniLor
Lhe sLaLus ol Lhe bank levy, as iL could sLill
be enacLed in luLure leqislaLion.
Leqal enLiLy divesLure:
Ad|usLed sLock basis
Delerred inLercompany qains/
losses
Lxcess loss accounLs
Previously lled qain recoqniLion
aqreemenLs
Foreiqn sLamp duLy
Foreiqn ellecLs
Delerred Lax asseLs and liabiliLies
and Lheir impacL on requlaLory
capiLal
OLher asseL disposiLions:
Ad|usLed basis
SLaLe and local income Lax ellecLs
Nonincome Lax ellecLs
Overall loreiqn loss recapLure
Considerinq Lhese issues durinq Lhe
planninq sLaqe ol a livinq will should
enable companies Lo idenLily, remedy
or miLiqaLe issues LhaL may noL be
lxable when Lhe business is lnancially
disLressed or lailinq. AlLer dralLinq a
livinq will, companies should review
Lhem periodically (as companies will
have Lo submiL Lheir plans on an annual
basis Lo Lhe Fed and FDlC which have Lhe
auLhoriLy Lo require chanqes) Lo ensure
Lhey conLinue Lo address Lhe Lax issues
mosL relevanL Lo Lhe currenL sLaLe ol
Lheir business.
1he AcL requires cerLain lnancial
insLiLuLions (nonbank lnancial
companies supervised by Lhe Federal
Reserve Board and bank holdinq
companies wiLh LoLal consolidaLed asseLs
equal Lo or qreaLer Lhan S50 billion) Lo
develop a "livinq will" LhaL ouLlines how
Lhey will wind down Lheir business il
laced wiLh severe lnancial disLress or
lailure. As leqal enLiLy raLionalizaLion may
be a ma|or ouLqrowLh ol Lhese recovery
plans, Lo ensure Lhe business's resoluLion
occurs in Lhe mosL LaxellcienL manner
possible, companies should consider Lhe
lollowinq issues when developinq Lheir
livinq wills:
DebL resLrucLurinq:
CancellaLion ol debL income
SLaLe and local income Lax ellecLs
Cain due Lo subsLanLial
modilcaLions under SecLion 1001
NonUS ellecLs
RepaLriaLion:
L&P pools
AvailabiliLy ol previously Laxed
income accounLs
Foreiqn Lax crediLs (direcL and
indirecL)
CrediLabiliLy ol loreiqn Laxes
Foreiqn currency ellecLs
Delerred Lax asseLs and liabiliLies
and Lheir impacL on requlaLory
capiLal
Pecovery and resolution planning
("living wills")
4 US FinanciaI Refcrm Act Has Sinificant Tax !mpIicaticns
5urplus lines
insurance
companies
1he AcL provides LhaL a policyholder's
home sLaLe will qain Lhe sole Lax
collecLion and requlaLory auLhoriLy
over mulLisLaLe insurance policies in Lhe
nonadmiLLed (surplus lines) insurance
and reinsurance markeLs. 1he provision
has been welcomed by Lhe insurance
indusLry because ol expecLaLions LhaL iL
will improve Lhe ellciency ol Lhe non
admiLLed insurance markeL. ProponenLs
ol Lhe chanqe also say iL will make
properLy and liabiliLy insurance more
readily available Lo consumers.
Under currenL law, mosL sLaLes require
paymenL ol an allocaLed porLion ol Lax
on mulLisLaLe risks, buL several sLaLe
sLaLuLes impose Lhe Lax on Lhe enLire
qross premium ol a mulLisLaLe risk,
creaLinq a "double Lax" on a porLion ol
Lhe premium in some LransacLions. 1he
provision in Lhe AcL would prevenL such
double LaxaLion by providinq LhaL Lhe
policyholder's home sLaLe would have
Lhe sole Lax collecLion and requlaLory
auLhoriLy over such policies.
Conclusion
1he AcL may have siqnilcanL Lax
implicaLions lor companies LhaL musL
comply wiLh iLs provisions. Failure
Lo consider Lhese implicaLions could
ellecLively increase Lhe cosL ol
complyinq. Accordinqly, companies
should include Lheir Lax deparLmenLs and
Lax advisors in Lheir discussions abouL
how Lo comply wiLh Lhe new law Lo ensure
LhaL companies are implemenLinq Lhe
provisions in a Lax ellcienL manner.
OLher chanqes in Lhe AcL LhaL will impacL
execuLive compensaLion pracLices
applicable Lo lnancial insLiLuLions and
oLher public companies include:
Requirinq companies Lo demonsLraLe
how Lhe compensaLion Lhey paid
relaLed Lo Lheir lnancial perlormance
PermiLLinq shareholders Lo hold a
nonbindinq "Say on Pay" voLe on Lop
execuLives' compensaLion aL leasL
every Lhree years
PermiLLinq shareholders Lo hold a non
bindinq voLe on "qolden parachuLe"
severance paymenLs made Lo Lop
execuLives in connecLion wiLh an
acquisiLion, merqer, consolidaLion,
sale or oLher disposiLion ol all or
subsLanLially all ol Lhe asseLs ol Lhe
company
Requirinq companies Lo implemenL a
policy Lo clawback excess incenLive
compensaLion paid Lo currenL or
lormer execuLive ollcers durinq a
Lhreeyear "look back" period excess
compensaLion musL be clawed back
in Lhe evenL Lhe company is required
Lo issue an accounLinq resLaLemenL
based on erroneous daLa due Lo
maLerial noncompliance wiLh any
lnancial reporLinq requiremenL under
Lhe securiLies laws, reqardless ol
wheLher Lhe execuLive was involved
in Lhe misconducL LhaL led Lo Lhe
resLaLemenL
Requirinq members ol Lhe
compensaLion commiLLee ol each
public company Lo be independenL
direcLors and requirinq Lhe
commiLLee Lo have Lhe auLhoriLy
Lo hire independenL compensaLion
consulLanLs, leqal counsel and oLher
advisors
Incentive
compensation
1he AcL Lasks Federal requlaLors wiLh
issuinq quidance nine monLhs alLer
enacLmenL LhaL requires cerLain lnancial
insLiLuLions Lo reporL how Lheir incenLive
compensaLion plans are sLrucLured.
1he quidance musL also prohibiL Lhose
insLiLuLions lrom ollerinq incenLive
compensaLion plans LhaL encouraqe
"inappropriaLe risks" LhaL may |eopardize
Lhe lnancial healLh ol Lhe orqanizaLion.
1o avoid violaLinq Lhe prohibiLion on
inappropriaLe risk Lakinq, companies
will need Lo examine Lheir incenLive
compensaLion plans and assess
wheLher Lhey encouraqe recipienLs Lo
Lake inappropriaLe risks. ll Lhey do,
companies will need Lo modily Lheir
plans Lo comply wiLh Lhe new quidance.
Many lnancial insLiLuLions are currenLly
sub|ecL Lo recenLly released lnLerAqency
Final Cuidance on Sound lncenLive
CompensaLion Policies, which addresses
Lhe inLerplay beLween compensaLion and
risk.
Contact us
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is noL inLended Lo be a subsLiLuLe lor deLailed research
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SCORL No. FV0009
10071177^72 NY