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SIFMA Seeks Guidance on Derivative Payment Reporting Requirement

AUG. 28, 2020

SIFMA Seeks Guidance on Derivative Payment Reporting Requirement

DATED AUG. 28, 2020
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August 28, 2020

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue,
NW Washington, DC 20220

The Honorable Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable William M. Paul
Principal Deputy Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Dear Messrs. Kautter, Harter and Paul:

On April 20, 2020, The Securities Industry and Financial Markets Association (SIFMA)1 submitted a comment letter to the Treasury Department and the Internal Revenue Service (together, “Treasury”) on the qualified derivative payment (“QDP”) reporting requirements in Section 1.59A-6(b) of the final regulations under Section 59A2 (the “Final Regulations,” and the “QDP Reporting Requirement”). For your convenience, a copy of that letter is attached.3

We greatly appreciate the opportunity we were provided on July 8, 2020 to discuss our comments with Mr. Harter and others at Treasury. Following on that conversation, we wish to provide further information with respect to two topics which were raised during the call, and which we think provide further support for our request, made in our original letter, that Treasury clarify that mark-to-market gains and losses with respect to the securities leg of an intercompany securities lending or borrowing (“SBL”) transaction are not subject to the QDP Reporting Requirement, in the form of revised final regulations, a revenue procedure or another type of written authoritative guidance.

1. Availability of Non-Tax Records with Respect to Securities Borrowing and Loans

On our call, Treasury asked whether financial institutions maintain records of SBLs for non-tax purposes (for example, for regulatory purposes), and whether those records could be used to determine the amount of such marks on intercompany SBL transactions for purposes of the QDP Reporting Requirement. As explained below, while there are certain records kept for GAAP and regulatory reasons, those records cannot be used to determine the marks with the precision needed for QDP reporting. We first discuss the on balance sheet records that are kept (relating to collateral posting) and then discuss the off balance sheet records that are kept for regulatory purposes. The discussion focuses on one financial institution's experience; based on input from the SIFMA BEAT Task Force members (who represent that vast majority of the market share for securities borrows and loans), that financial institution's experience is believed to be representative.

Collateral Reflected on Balance Sheet

The financial institution's GAAP balance sheet does not record or reflect the value of securities that are borrowed or lent. Rather, for each security that is borrowed (intercompany or third party), the financial institution will post cash or securities as collateral.4

If the posted collateral is in the form of cash, it is the amount of this cash collateral that is reflected on the balance sheet.5 If, on the other hand, the posted collateral is itself (other) securities, that collateral is not shown on the balance sheet. Substantial amounts of collateral are in the form of securities; at any point in time, depending on market and business conditions, in excess of half of all intercompany securities borrowed could be collateralized with other securities.

For each intercompany transaction, collateral will be posted generally in excess of the value of the borrowed securities. The amount of collateral posted may change either because there is a change in the market value of a borrowed security or because there is a change in the quantity of securities that are borrowed. Typically, a security borrow will be over-collateralized. The chart below provides examples of typical percentages of initial collateral for different security types with respect to intercompany SBLs:

Collateral Type

Minimum Credit Rating

Collateral Percentage

Cash (USD)

N/A

100% - 105%

G6 Government Debt

A- (S&P) and A3 (Moody's)

105%

Other Government Debt

A- (S&P) and A3 (Moody's)

110%

Corp Debt (of companies listed Permissible Equity Indices only)

A- (S&P) and A3 (Moody's)

110% - 120%

Equity — Permissible Indices: Euro Stoxx, FTSE 350, S&P 500, Nikkei 225, CAC 40, DAX 30, MIB 30, BEL 20, HEX 25, AEX, SAR, Hang Seng 33, OMX, SMI

A- (S&P) and A3 (Moody's)

105% - 110%

It is therefore not possible to extract from the balance sheet the changes attributable to price movements or changes in value of borrowed or loaned securities (including changes in the value of securities posted as collateral, which posting is itself an SBL). This is because, as noted above, (1) securities collateral is not recorded on the balance sheet, (2) changes in the amount of collateral can occur by reason of changes in the quantity of securities that are borrowed (and not just because of changes in value) and (3) changes in the value of collateral only approximate changes in price movements of an SBL.

Transactions Reflected off Balance Sheet for Regulatory Purposes

The financial institution does have various internal systems to identify, for risk management and regulatory purposes, the market value of off-balance sheet securities borrowed or loaned. However, it is not feasible to extract from these off-balance sheet risk systems changes in the price of the securities that occurred on a given SBL transaction.

Specifically, the financial institution's systems do not maintain a cost basis for each security that is borrowed. Therefore, it is not possible to determine, across millions of SBLs, whether a change in the value of securities that are borrowed is attributable to a change in the value of the securities, or a change in the amount of securities that are borrowed. The example below illustrates the difficulty.

Day 1. Our systems reflect that Party A is borrowing 100 shares of Stock X with a value of $1/share from Party B collateralized with $100 of cash.6

Day 2. Stock X increases in value to $1.20/share and Party A borrows an additional 10 shares. Party A posts an additional $32 of cash collateral. The financial institution's systems reflect that Party A is borrowing 110 shares of Stock X with a value of $1.20/share from Party B collateralized with $132 of cash.

Day 3. Stock X decreases in value to $1.10/share and Party A returns 5 shares. $16.50 of collateral is returned to Party A. The financial institution's systems reflect that Party A is borrowing 105 shares of Stock X with a value of $1.10/share collateralized with $115.50 of cash.

Difficulty: Although the financial institution's systems would track, in this case, the number of shares and total value of Stock X that is borrowed, the systems do not maintain a cost basis for each share (and don't maintain a pooled cost basis). While the financial institution would be able to identify that the number of shares borrowed increased on Day 2 and decreased on Day 3 —  and that the total value of shares borrowed increased on Day 2 and decreased on Day 3 — the financial institution would not be able to identify when particular shares were originally borrowed (e.g., Day 1 (FIFO) or Day 2 (LIFO)), the cost basis of the borrowed shares or the corresponding change in value of those shares through the life of the borrow transaction (e.g., $0.10/share (FIFO) or $-0.10/shares (LIFO)) without building systems to track the cost basis of each security and a system to then determine profit and loss from each transaction.

The same difficulties apply when securities are pledged as collateral as the financial institution's systems also do not maintain the cost basis for each such pledged security. Therefore, since the posting of collateral is itself an SBL transaction, it would not be possible to determine the change in value of any particular pledged security.

An expansion of existing capabilities to satisfy the proposed methodology would require significant technology investment that would be a bespoke toolset exclusively for this purpose without additional business function and without the ability to reconcile that information generated with anything on the financial institution's general ledger or other financial systems.

Prime Brokerage

The obstacles to extracting SBL information are even worse with respect to securities borrowed as part of the financial institution's prime brokerage business. As noted in our April letter, in that line of business, US securities are borrowed from a pool which holds securities owned by both US customers and non-US customers. Given the fungibility of securities in the pool, it is inherently unknowable whether a particular security borrowed should be viewed as borrowed from a US person or a non-US person. This is important for purposes of this discussion because a non-US customer will typically have its contractual relationship with the financial institution's non-US affiliate. To the extent the securities of the non-US customer would be the ones deemed borrowed, we believe that the correct characterization of that transaction for US tax purposes is that (i) the non-US customer is deemed to have loaned the securities to the financial institution's non-US affiliate (with whom it has the contractual relationship) and (ii) the non-US affiliate is deemed to have loaned the securities to the financial institution's US affiliate. In other words, the borrowing creates an intercompany SBL.

Outside the BEAT context, the financial institution resolves the inherent unknowability (and satisfies the reporting requirements of Section 6045) pursuant to the lottery process described in Notice 2003-67. However (a) securities that may be treated as borrowed for federal income tax purposes under Section 6045 are not recorded on any of the systems described above and (b) the lottery process is only employed on days that payments are made by the issuers of such securities.

2. Distinction Between SBLs and Other Derivative Transactions

On our call, Treasury asked whether SIFMA's argument in the original comment letter that negative marks on an SBL are not base erosion payments also applies to negative marks on other derivative transactions, and, if so, whether that would call into question the entire BEAT Netting Rule, at least for purposes of the QDP Reporting Requirement. We understand that the purpose of the BEAT Netting Rule is to capture in a non-distortive manner the amount of deductions, including marks, that properly go in to the denominator of the base erosion percentage. In the case of derivatives and physical securities that are marked to market, it does so in a logical and effective manner by drawing on information readily available from a taxpayer's financial books and records. It makes sense to use this same methodology for purposes of the calculating QDPs as well, notwithstanding that marks are not base eroding payments: such use makes the QDP calculation both far easier than it would otherwise be, and more auditable, given the ability to tie both the QDP and the denominator amounts relating to derivatives to the taxpayer's books and records, thereby making comparison of the amounts far easier. These considerations outweigh the concern that inclusion of marks (both positive and negative) in the calculation of the QDP amounts may cause a theoretical distortion in the “correct” amount of the QDPs. That these practical considerations ought to outweigh this theoretical concern is especially true because QDPs are, by definition, excluded from the calculation of the taxpayer's base erosion payments. In other words, whether or not marks belong in the QDP calculation, they clearly are not base erosion payments, either because, as the Treasury preamble states (in the case of negative marks), they are not base erosion payments to begin with or because, even if arguendo they would be (but for the QDP exception), they are excludable as QDPs. In either case, there is no harm — and, for the reasons noted, practical benefit — in having marks taken into account in the QDP calculation as the BEAT Netting Rule mandates.7

The considerations just noted, in the case of derivatives, for using the BEAT Netting Rule in the QDP calculation generally do not exist in the case of SBLs:8 taxpayers generally have no ability to apply the BEAT Netting Rule to such transactions given that there are no financial records that track these amounts with the necessary precision.9 This means that financial institutions will have no practical choice but to disadvantage themselves by not enlarging the denominator in the case of third party SBLs given the unavailability of the information needed to apply the BEAT Netting Rule to such transactions. This same unavailability of information on third party transactions — in particular, the unavailability of information on marks — applies to intercompany SBLs captured in the QDP report. It therefore makes no sense to prioritize formal parallelism (between QDP reporting on derivatives and that on SBLs) above all else by requiring taxpayers to include information on marks in the latter (SBLs) case merely because it is included in the former (derivatives): the information is not available in the latter case with the necessary precision, and it could not in any event be used for comparison with third party transactions (since the deductions from such third party transactions are not being calculated). And the inappropriateness of such inclusion in the case of SBLs is reinforced by the points made in the previous paragraph as to why marks ought not to be part of the QDP calculation to begin with.

In summary, the considerations that exist in the case of derivatives for including marks in the QDP calculation and thus potentially distorting the theoretically correct QDP amount do not exist in the case of SBLs.10

We again wish to express our appreciation for the effort that went into drafting the Final Regulations, and to thank Treasury for its continuing consideration of the special issues that the BEAT rules, and especially the QDP Reporting Requirement, present for financial institutions. Should you have questions or wish to further discuss, please do not hesitate to contact me at (202) 962-7440 or jwall@sifma.org, or our outside counsel Michael Mollerus at Davis Polk & Wardwell LLP at (212) 450-4471 or michael.mollerus@davispolk.com.

Respectfully submitted,

Jamie Wall
Executive Vice President, Advocacy
Securities Industry and Financial Markets Association

Attachment

cc:
Douglas L. Poms
International Tax Counsel
Department of the Treasury

Kevin C. Nichols
Senior Counsel (International Tax Counsel)
Department of the Treasury

Erika Nijenhuis
Senior Counsel (International Tax Counsel)
Department of the Treasury

Sheila Ramaswamy
Attorney-Advisor
Internal Revenue Service

Karen Walny
Attorney
Internal Revenue Service

Julie Wang
Attorney
Internal Revenue Service

John P. Stemwedel
Attorney
Internal Revenue Service

Azeka J. Abramoff
Attorney
Internal Revenue Service

Peter Merkel
Attorney
Internal Revenue Service

FOOTNOTES

1SIFMA is the leading trade association for broker-dealers, investment banks and asset managers operating in the U.S. and global capital markets. On behalf of our industry's nearly 1 million employees, we advocate for legislation, regulation and business policy, affecting retail and institutional investors, equity and fixed income markets and related products and services. We serve as an industry coordinating body to promote fair and orderly markets, informed regulatory compliance, and efficient market operations and resiliency. We also provide a forum for industry policy and professional development. SIFMA, with offices in New York and Washington, D.C., is the U.S. regional member of the Global Financial Markets Association (GFMA).

2Except as otherwise indicated, all “Section” references refer to sections of the Internal Revenue Code of 1986, as amended (the “Code”), or to sections of the Treasury Regulations promulgated thereunder.

3Capitalized terms used and not otherwise defined herein are used as defined in the original letter.

4When Party A borrows securities from Party B and posts other securities with Party B as collateral (which posting is typically equivalent to a loan of those securities by Party A to Party B), it is the form of transaction that dictates this result, viz., that the securities borrowed by Party A are considered the ones borrowed and the ones given to Party B are the ones posted as collateral. As noted below, this has practical significance because it dictates the collateral posting rules. In any case, we assume that for US tax purposes, the securities posted by Party A as collateral should (also) be deemed to be an SBL transaction.

5Specifically, it is reflected as a liability on the balance sheet of the securities lender and as an asset on the balance sheet of the securities borrower.

6For simplicity, this example assumes that collateral is posted at 100%.

7The only situation in which the statement in the text (that inclusion of marks in the QDP amount cannot, by definition, distort the amount that is treated as a base eroding payment) would not be accurate would be in the very rare case that the derivatives fail to meet the QDP definition for reasons other than a failure to meet the reporting requirement. In that event, though, (a) the inaccuracy of the base eroding amount is not attributable to the inclusion of marks in the QDP report and (b) the taxpayer would in any case be required to determine the actual base erosion payment amounts.

8We recognize that obligations to return borrowed securities and rights to receive back loaned securities are themselves “derivatives” as that term is defined in Section 59A(h)(4)(A); this letter is premised on that recognition. It is nevertheless critical, as we discuss in the text, to distinguish between those derivatives that are tracked for financial statement purposes and those — specifically positions with respect to borrowed and loaned securities — that are not. For convenience, the text categorizes the latter as “not derivatives” notwithstanding their inclusion in Section 59A(h)(4)(A).

9There are two limited exceptions. The first is for cases where a security borrowed by a financial institution is shorted to a third party and where the financial information relates to that third party transaction (but even here it is not possible to trace any particular short position to any particular borrowing). The second is for cases where a security that is owned outright (versus cases where the security is borrowed from another taxpayer) is loaned out. In that case, some financial institutions are able to track marks on those securities in a manner that allows them to take those marks into account in calculating the denominator (consistent with the BEAT netting rule). In such a case, the tracking of such marks would continue during a period that such owned-outright security was loaned out; in fact, it would be difficult to distinguish marks on “unloaned” securities from marks on loaned securities.

10Consistent with the above, SIFMA agrees that it would be reasonable for the IRS to require that to the extent that (a) a taxpayer does use the BEAT Netting Rule for SBLs (and not merely shorts of borrowed securities and loans of securities it owns outright) for purposes of the denominator of the base erosion percentage, and (b) the method used for calculating such denominator amounts allows calculation of corresponding amounts for purposes of such reporting, it should also be required to use the BEAT Netting Rule for purposes of QDP reporting. Thus, for example, assume that in calculating the denominator, a taxpayer (i) tracks marks on securities that it owns outright (versus securities that it borrows to relend), (ii) tracks those marks both during the period it does not lend out such securities and the period that it does, and (iii) is able to distinguish marks on such securities while they are loaned out from marks on such securities while they are not loaned out. In that case, it should be consistent in taking into account marks on loaned securities for purposes of the QDP reporting requirement if the security was loaned to a related non-US borrower, albeit only to the extent that it is knowable that the related non-US person was actually the borrower. As noted in footnote 3, though, we believe that few, if any taxpayers will — even if they have the ability to track marks on securities owned outright — have the ability to distinguish between marks on unloaned securities and marks on loaned securities. Of course, of relevance here, marks on loaned securities ought not to be viewed as base eroding payments in any case, and the IRS thus would not be deprived of any relevant information by the non-inclusion of such marks in the QDP report.

END FOOTNOTES

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