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Banks Seek Exceptions, Changes to Proposed Debt-Equity Regs

JUL. 7, 2016

Banks Seek Exceptions, Changes to Proposed Debt-Equity Regs

DATED JUL. 7, 2016
DOCUMENT ATTRIBUTES

 

July 7, 2016

 

 

The Honorable Mark Mazur

 

Assistant Secretary for Tax Policy

 

Department of the Treasury

 

1500 Pennsylvania Avenue, NW

 

Washington, DC 20220

 

 

The Honorable John Koskinen

 

Commissioner

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

 

 

The Honorable William Wilkins

 

Chief Counsel

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

 

Re: Proposed Regulations Under Section 385 (REG-108060-15)

 

Dear Messrs. Mazur, Koskinen, and Wilkins:

Citigroup Inc., Bank of America Corp., and JPMorgan Chase & Co. submit the following comments regarding the proposed regulations (the "Proposed Regulations") under Section 385 of the Internal Revenue Code of 1986, as amended (the "Code").1 Very generally, the Proposed Regulations would: (1) automatically treat as stock any intercompany debt issued by a group member in, or within a six-year window around, certain transactions including the payment of dividends (the "Funding Rule")2; and (2) automatically treat as stock any intercompany debt that fails to meet specific documentation requirements (the "Documentation Rule").3 This comment letter describes concerns arising under the Funding and Documentation Rules for large U.S.-headquartered banking groups with both banking and broker-dealer4 businesses in the United States and internationally (referred to herein as "financial services groups"), with a specific focus on the activities of regulated banks and broker-dealers that are subsidiaries of bank holding companies.

Debt permeates every aspect of a bank's and a broker-dealer's activities. While companies in other industries use debt to finance their core businesses, debt is the core of a financial services business. Intercompany debt is an important and unavoidable subset of this debt: it allows the group to manage cash -- its inventory -- in an optimal manner to satisfy the financing demands of customers, reducing cost and risk. Banks and broker-dealers need intercompany deposits and other borrowings in order to perform core financing functions in the ordinary course of business. Debt -- including intercompany debt -- is fundamental to their liquidity and is a necessary component of the overall capital structure.

Moreover, banks and broker-dealers are highly regulated by a combination of governments, agencies, and self-regulatory organizations whose mandate is to ensure these institutions' soundness and ultimately that of the financial system. Regulators aim to prevent these financial services groups from incurring excessive debt or lending to entities that are not financially sound, thus already performing a principal function of the Proposed Regulations. The ability of a financial services group to accomplish the types of base erosion activities targeted by the Proposed Regulations is already limited due to regulatory requirements, including explicit limitations on related party debt. At the same time, regulators require or encourage banks and broker-dealer subsidiaries of large banking organizations to have intercompany debt in their capital structures to meet important supervisory objectives, because debt offers flexibility that equity does not and can be used to move capital and liquidity around the group in times of financial stress. In addition, regulators will generally monitor (and at times can influence the timing of) distributions from entities within the group, which may result in the unavoidable application of the Funding Rule.

As a result of these unique factors, the core business functions of banks and broker-dealers would inevitably trigger recharacterization of related-party debt instruments under the Funding Rule in situations that bear no resemblance to the fact patterns identified by the Treasury Department ("Treasury") and the Internal Revenue Service (the "IRS") as giving rise to policy concerns. To prevent this result, the scope of the Funding Rule must be narrowed. In this letter, we focus on a possible exception from the Funding Rule for regulated banks and broker-dealers that would operate to alleviate our primary concerns.5 We also propose modifications to the Documentation Rule that would ease the rule's implementation and administration.

Section I describes the general business and debt funding profiles of banks and broker-dealers, and shows how intercompany debt is a vital part of their operations. Section II provides an overview of the regulatory and supervisory constraints under which banks and broker-dealers operate worldwide. Finally, Section III recommends how the Proposed Regulations should be modified to account for the special business and regulatory considerations affecting financial services groups.

 

I. Debt in a Global Financial Services Business

 

A. Our Businesses
Together with our subsidiaries, we provide a broad range of financial services, including retail, investment and commercial banking, brokerage, investment management, and financial transaction processing services. We serve clients throughout the world, including individuals, large and small businesses, governments, and institutions. We have truly international, integrated businesses, and our clients benefit greatly from our international footprint and ability to address their global or regional needs.6

For each of us, banking and dealing in securities and derivatives are primary business segments. We conduct our banking operations through U.S. and non-U.S. banking subsidiaries and branches. Our securities broker-dealer operations are conducted through U.S. broker-dealers registered with the Securities and Exchange Commission ("SEC") and non-U.S. securities dealer subsidiaries.7 Our swap dealing businesses are conducted primarily through our main banks -- Bank of America, N.A., Citibank N.A. and JP Morgan Chase Bank, N.A. -- each of which is registered with the Commodity Futures Trading Commission ("CFTC") as a swap dealer, as well as through non-bank subsidiaries that are also CFTC-registered swap dealers. Our futures and other derivative businesses are conducted through our CFTC-registered futures commission merchants ("FCMs") and non-U.S. derivatives subsidiaries.

B. External Sources of Debt Funding
Debt is an essential component of the business of a financial services group. Banking is fundamentally a spread business: banks seek to borrow cash at a cheaper rate than the rate at which they can lend it out. Accordingly, debt is crucial to our operations. Banks have historically had leverage multiples (i.e., the ratio of assets to equity)8 of 10:1 or higher.9 Similarly, broker-dealers also incur indebtedness in the ordinary course of their daily business, including to provide customer services and to finance their operations. In short, these businesses normally operate with significant amounts of debt relative to their assets.

In other industries, operational need drives the demand for total funding, and management decisions shape the choice between debt and equity. By contrast, a regulated bank or broker-dealer's business model dictates its balance sheet. Because their core business is financial intermediation, customer-related activity drives the liability as well as the asset side of the balance sheet. Regulatory requirements, as discussed in Section II below, also reflect binding constraints on the balance sheet.

External debt funding flows into our banks and broker-dealers in different ways, reflecting the different natures of their businesses.10 We raise significant short-term debt funding directly at the level of our operating subsidiaries, through customer transactions. In particular, banking subsidiaries and branches are primarily funded through the deposits they take in from customers. For securities broker-dealer subsidiaries, secured debt in the form of sale and repurchase transactions (commonly referred to as "repo" transactions) represents a principal source of funding. Long-term unsecured debt, typically raised from investors in the capital markets by our groups' holding companies (Citigroup Inc., Bank of America Corp., and JPMorgan Chase & Co., referred to herein as our "top-tier parent entities"), also plays an important role in our bank and broker-dealer activities. It has special value to us as a category of debt funding due to its multi-year contractual maturity structure, in contrast to many of our groups' shorter-term sources of funding, and supplements the debt funding raised directly by our operating subsidiaries.11 In 2015, Citigroup Inc. issued $44.6 billion, Bank of America Corp. issued $26.4 billion, and JPMorgan Chase & Co. issued $79.3 billion of long-term debt to the public. The proposed TLAC regulations promulgated by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), discussed below, will result in additional long-term debt being raised in the next few years.

C. The Crucial Role of Intercompany Debt
As part of their balance sheet management, banks and broker-dealers must engage in a complex process of liquidity, currency and interest rate risk management to balance the asset and liability sides of the equation in order to optimize the use of cash and financial assets while limiting risk. Intercompany debt is fundamental and inseparable from this process, driven by customer, business and regulatory -- rather than tax -- reasons.

Intercompany funding transactions occur on a daily basis among our banking and broker-dealer entities throughout the world. These transactions enable our treasury functions to manage liquidity imbalances and risk arising in the ordinary course from customer transactions, thereby ensuring our entities' soundness and sustainability. Specifically, these transactions most commonly arise in the context of (1) intercompany deposits across our global banking networks, (2) repos and other secured financings, and (3) longer-term senior debt raised at our top-tier parent entities and on-loaned to our operating subsidiaries.

1. Intercompany Debt in the Banking Business12
Banking is about financial intermediation -- receiving cash from depositors around the world and making it available to other customers. In effect, cash is a bank's inventory, and the interest it pays to obtain that cash is its cost of goods sold. Debt is the means by which cash is transmitted; both from external sources in the form of customer deposits and loans, and within the organization, from one banking subsidiary or branch to another. For a banking organization, the ability to move cash via debt is not merely a matter of convenience, it is essential. These transactions create genuine liabilities: they involve fixed sums and creditor claims, rather than a sharing of profits.

As described above, our banking subsidiaries and branches fund themselves primarily through the deposits they take in from customers. They supplement their deposits with longer-term intercompany debt that reflects a portion of the debt raised in the capital markets by the top-tier parent entity. While this represents the basic pattern of debt funding for our banking operations, at any given time there will be a need to move cash from one place to another among our banking entities and branches.

On a daily basis, our subsidiaries and branches make hundreds of intercompany deposits in order to manage liquidity, interest rate exposures and currencies among the various entities. These transactions are centralized in geographical hubs, with each hub receiving deposits from bank branches and subsidiaries and placing deposits with other bank branches and subsidiaries as necessary. The transactions are largely formulaic, driven by processes designed to optimize our worldwide management of liquidity, interest rate, and currency risks within the risk governance framework established by management.

Liquidity. Intercompany deposits allow banks to manage the liquidity needs of their subsidiaries and branches and, ultimately, the needs of their customers. Specifically, these deposits enable us to move cash from branches and subsidiaries that have excess liquidity -- i.e., the deposits taken in exceed the customer demand for loans -- to those branches and subsidiaries whose customers have a greater demand for loans than can be served by local deposits. For example, if on July 15, a Hong Kong banking subsidiary has a quantity of deposits that exceeds the local demand for customer loans, it will make a deposit into, for example, the New York branch of the U.S. bank. If, as of August 15, there is greater demand for cash in Hong Kong, the Hong Kong subsidiary may withdraw the outstanding deposit, and instead lend the cash to local customers. These daily intercompany transfers of cash enable our banking subsidiaries and branches to move cash to where it is needed around the world, making funding available to their customers at a lower cost than would apply in the absence of these transfers.

Interest Rate Risk. Banks also use intercompany debt as a way to manage the interest rate exposure of their branches and subsidiaries. As noted, banking remains fundamentally a spread business: banks seek to borrow cash at a cheaper rate than the rate at which they can lend it out. If the borrowing and lending involve interest rates with different tenors -- meaning, periods of time between interest rate resets -- a banking business will be exposed to volatility in its profits. Moreover, banks seek to manage their duration risk, meaning that they seek to balance the average term to maturity of their assets and liabilities.13 Because each of our local bank branches or subsidiaries strives to be self-sustaining on a standalone basis, we generally monitor their assets and liabilities to make sure that there is a balance between them in tenor and duration, taking account of the entire portfolio of assets and liabilities at that branch or subsidiary. We use intercompany deposits or intercompany loans to manage the exposure of each local branch and subsidiary to interest rate risk arising from these mismatches in its asset and liability portfolio. For example, if a Singapore banking subsidiary has customer demand deposits with an average three-month tenor and a loan to a customer with a six-month tenor, the subsidiary may borrow on an intercompany basis with a six-month tenor, and lend on an intercompany basis with a three-month tenor, in order to balance its interest rate risk.

Currency. Finally, intercompany deposits enable us to move foreign currencies to their natural home locations on a daily basis. Generally, currencies held by a bank overnight are transmitted to and held at the central bank that is the issuer of that currency. For example, dollars held by a U.S. bank are deposited with the Federal Reserve Bank, while euros are deposited with the European Central Bank.14 So, for example, U.S. dollars held by a Hong Kong banking subsidiary at the end of the day are automatically swept into its deposit account with its U.S. bank affiliate, which in turn deposits its dollars overnight into its account with the Federal Reserve Bank.

The movements of cash described above are not -- in substance -- distributions or contributions of equity. The excess liquidity that arises in the ordinary course of business of a banking subsidiary is not a deployable asset that can be distributed through a dividend or used to pay down longer-term debt. Because deposits are often demand obligations, this liquidity can fluctuate to a significant degree, so that using it to permanently adjust the subsidiary's internal capital structure would not make business sense. Moreover, liquidity, interest rate exposure, and currencies fluctuate on a continuous basis, and therefore a financial services group needs the flexibility to rapidly move cash to meet ordinary course, customer driven demands. It would be impractical and imprudent to attempt to use equity for these purposes. And, as described in Section II below, the regulatory regimes we operate under basically preclude the use of equity for these purposes; among other things, a banking subsidiary's host country bank regulator is unlikely to permit equity and dividends to be paid out freely.

2. Intercompany Debt in the Broker-Dealer Business
As with our banking subsidiaries, our broker-dealers obtain a significant portion of their debt funding through transactions directly with customers, but in the form of repos or repo-like financing transactions rather than deposits. The broker-dealers also rely on longer-term intercompany debt that reflects a portion of the debt issued by the top-tier parent entity in the capital markets. In addition to this longer-term debt, other intercompany debt transactions arise on a daily basis among the broker-dealer subsidiaries, reflecting the need to move cash and assets among them.

For a broker-dealer, providing financing to customers is a core function. For example, for our securities broker-dealers, these customer loans typically take the form of obligations collateralized by securities, such as repos and stock loans. For regulatory and customer preference reasons, a customer will typically establish a customer relationship with a single broker-dealer entity within a financial services group (i.e., the prime broker) for all of its transactions. However, the natural home for the security that is the subject of a customer lending transaction may be in a different jurisdiction as a result of various factors, most importantly, where the market for that security is most liquid. The disconnect between the customer location and the location of the securities being purchased or financed frequently results in the creation of an intercompany debt obligation between two of our broker-dealers in different jurisdictions.

For example, assume a U.S. client of a U.S. broker-dealer wishes to borrow cash against its holdings of gilts, the securities issued by the British government. In order to increase liquidity and for other business needs, the customer enters into a repo transaction under which it sells the gilts to the U.S. broker-dealer, which is its prime broker and with which it has a customer relationship, and agrees to repurchase the gilts at the conclusion of the repo. The group's U.K. broker-dealer can more easily use gilts in its ordinary course of business because the natural market for gilts is located in the United Kingdom (where gilts are issued and traded in the secondary markets). Accordingly, to satisfy the customer's desire to borrow against its gilt position, the U.S. broker-dealer will typically enter into a back-to-back transaction with the U.K. broker-dealer, such as an intercompany repo, to hedge the customer facing repo, and then the U.K. broker-dealer will use the gilts in its ordinary course of business.

As is true of intercompany deposits between banking subsidiaries, the customer and market activity that necessitates intercompany repos and other financings between affiliated broker-dealer subsidiaries could not be replicated by equity. This intercompany activity represents the core business of a broker-dealer, in which debt is used in a fundamentally and significantly different manner than in the case of a non-financial services company.

3. Long-Term Intercompany Debt in Bank and Broker-Dealer Businesses
In addition to the day-to-day debt obligations that are created among our banking entities and among our broker-dealer entities, longer-term intercompany debt is used to fund our non-bank broker-dealer entities and, to a lesser extent, our banking entities. This category of debt is important to us because it diversifies and supplements the debt raised at the operating subsidiaries (primarily customer deposits and repos) and allows us to manage duration and tenor risk by issuing debt with staggered maturity dates and varying interest rate reset mechanisms and dates.

Like many corporate groups, we each issue most of our public long-term debt through our publicly-listed top-tier parent entity. Centralizing our debt offerings at the holding company level in this way allows us to present a single face and rating to capital markets investors. Our ability to access a stable source of funding from the debt capital markets is an important consideration to investors and regulators: a financial service group's credit rating and ability to borrow demonstrates its viability.

It would be unworkable for these intercompany transactions to be formed as equity rather than debt. For one thing, equity would conflict with important regulatory and supervisory objectives described in Section II, including resolution planning, avoiding double leverage, and retaining the ability to bring capital back from regulated subsidiaries in different jurisdictions. Moreover, at the operating subsidiary level, this debt serves the important risk management purposes described above, assisting the subsidiary to manage its standalone interest rate tenor and duration risks. For the same reasons, it would be undesirable for an operating subsidiary to use its profits to pay down this intercompany debt in lieu of paying dividends.

 

II. Regulation and its Impact on Intercompany Debt

 

As financial services groups, our top-tier parent entities (as financial holding companies) and each of our banking and broker-dealer subsidiaries are heavily regulated by multiple governmental agencies in order to ensure our financial soundness and protect our depositors, customers and counterparties, as well as the financial system. We are regulated on a consolidated or umbrella basis and our banks and broker-dealers are also regulated on a standalone basis. Regulators oversee every aspect of our business, including monitoring the debt we issue and the loans we make. Therefore, while the descriptions of intercompany debt in Section I focused on a financial services group's business needs as a driver of these types of debt, this debt is also fundamentally shaped by regulation.

In particular, prudential banking regulations impose regulatory capital requirements, meaning a minimum amount of common equity and certain preferred stock and subordinated debt funding (collectively referred to as regulatory capital) relative to assets, on both a risk-weighted and absolute basis. The regulatory framework also requires limits on leverage, limits on large exposures or risks, and resolution planning, including a capital structure designed to facilitate the orderly resolution of the parent corporation and its material legal entities in the event of future material financial distress or failure.

The regulatory capital rules recognize that debt and leverage are necessary to the operation of a financial services group in its role as a financial intermediary, but place limits on the extent to which a financial services group may employ leverage in order to preserve the safety and soundness of the individual institution and the financial system. In certain contexts, intercompany debt is encouraged or even required by regulation or supervisory guidance, because it can serve as a tool to enable a financial services group's movement of assets within the group in times of stress. For example, regulators require long-term debt as a component of capital.

The net effect of this regulatory framework is, first, that our regulated entities cannot take on excessive intercompany debt and, second, that regulatory compliance dominates the planning for our capital structures in a way that essentially forecloses tax planning with debt in regulated entities.

A. Regulatory Constraints on Intercompany Debt
We are subject to regulation and supervision by a number of bank regulatory agencies. Each of our top-tier parent entities is a registered bank holding company that has elected to be treated as a financial holding company under the Bank Holding Company Act. Accordingly, we are regulated and supervised on a consolidated basis by the Federal Reserve Board. Our national banks are regulated and supervised by the Office of the Comptroller of the Currency ("OCC"). The Federal Deposit Insurance Corporation (the "FDIC") also has examination authority for all banking subsidiaries whose deposits it insures. Overseas branches of our national banks are regulated and supervised by the Federal Reserve Board and OCC and overseas subsidiary banks by the Federal Reserve Board. These overseas branches and subsidiary banks are also regulated and supervised by regulatory authorities in the host countries, as discussed further below. In addition, the Consumer Financial Protection Bureau regulates consumer financial products and services.

These bank regulatory agencies impose many regulatory limitations on us, including requirements for banks to maintain reserves against deposits, restrictions on the types and amounts of loans that may be made and the interest that may be charged, and limitations on investments that can be made and services that can be offered. We are also subject to regulatory capital requirements issued by the Federal Reserve Board, referred to as the U.S. Basel III rules. These rules establish an integrated capital adequacy framework, encompassing both risk-based capital ratios and leverage ratios.15 Under these rules, each of us had a common equity tier 1 risk-based capital ratio in excess of 10% as of March 31, 2016.16

In addition, there are restrictions on loans and other transactions between our U.S. subsidiary banks and their non-bank affiliates. Specifically, Section 23A of the Federal Reserve Act prohibits our U.S. subsidiary banks from lending more than 10% of their capital and surplus to a single non-bank affiliate, and more than 20% to all affiliates, and requires that most such transactions be on a secured basis. Section 23B of the Federal Reserve Act requires that all such transactions be on arm's length market terms.

Our U.S. broker-dealers are registered under the Securities Exchange Act of 1934 (the "Exchange Act"). Their primary regulator is the SEC. They are also members of, and subject to the oversight of, the Financial Industry Regulatory Authority. Certain of our subsidiaries are also swap dealers and FCMs registered with the CFTC. These regulated entities are members of, and subject to the oversight of, the National Futures Association. Each of these bodies administers a complex set of rules designed to protect customers and ensure the safety of the U.S. securities and derivatives markets as a whole.

SEC-registered broker-dealers must maintain a minimum ratio of net capital to measures of indebtedness specified by regulation (which are measures of the broker-dealer's own indebtedness or, alternatively, customer-related receivables).17 To comply with these requirements, SEC-registered broker-dealers must abide by initial, ongoing minimum and excess net capital requirements. Minimum net capital depends on the nature of the SEC-registered broker-dealer's business. There are notification requirements for, and potential restrictions on the timing of, any reduction in excess net capital below certain levels.18

Non-U.S. regulators also limit the debt of a bank or broker-dealer. Each non-U.S. subsidiary or branch that conducts banking or dealing operations is subject to the relevant host country bank or broker-dealer regulatory regime and the oversight of that country's regulatory body, in addition to the oversight of the Federal Reserve Board. These host country regulators, and the relevant local laws, have a general objective of ensuring the soundness of that particular entity or branch in order to protect local depositors and customers. While all the regulators have a general interest in ensuring the viability of the group of entities as a whole, each local regulator necessarily monitors the branch or entity for which it bears primary responsibility. As a consequence, each of these branches and entities generally must be able to demonstrate that it is financially strong -- by meeting local capital requirements -- on a standalone basis.

By way of example, certain of our U.K. subsidiaries are subject to the European Union ("EU") Capital Requirements Directive (2013/36/EU), as transposed into U.K. law, and the Capital Requirements Regulation ((EU) No. 575/2013) (collectively, "CRD IV"), which together represent the EU's implementation of the international Basel III capital accords.19 A two-step regulatory capital analysis is required to determine the regulatory capital requirements with which a U.K. bank or investment firm must comply. The first step is a formulaic calculation of its minimum capital requirements. The second step involves the bank or firm carrying out the Internal Capital Adequacy Assessment Process (the "ICAAP"). In the ICAAP, the bank or firm will determine whether its particular risk profile and the level of its exposures mean that it should hold capital beyond the minimum required level. The relevant regulator must then perform a supervisory review of the ICAAP and can require the bank or firm to hold more capital if the regulator believes risks have not been adequately addressed.

Pursuant to CRD IV, the liquidity adequacy regime of the Prudential Regulation Authority (the "PRA"), which is responsible for the prudential regulation and supervision of certain banks and investment firms, such as ours, broadly requires banks to be self-sufficient for liquidity purposes; banks may only rely on other members of their group for support in limited circumstances and where they have received prior approval from the regulator. The PRA has been reluctant to grant this approval where a U.K. bank is seeking to rely on liquidity from non-U.K. subsidiaries. Under this regime, therefore, intra-group financing arrangements for the provision of liquidity will be subject to supervisory review and approval.

Although rules vary by jurisdiction, many jurisdictions constrain intercompany lending to a specified percentage (e.g., 25%) of the lending entity's capital. For example, the large exposure regime under CRD IV requires U.K. banks and certain other broker-dealer institutions to ensure that, in relation to their banking books, and subject to certain exemptions, the total amount of exposure to any counterparty or group of connected clients does not exceed 25% of eligible capital. Financial services groups may also have internal policies that serve as a single proxy for these various constraints. For example, Citi has a policy, which is applicable to each of its material legal entities as well as each group of entities or branches within a single country, that limits intercompany borrowing to 20% of the total debt (secured and unsecured) obligations of that entity or group. These limits help to ensure that Citi's banks and broker-dealers are financially strong on a standalone basis and, accordingly, reduce the risk that a local regulator will feel compelled to "ring fence" assets in its jurisdiction in order to protect its constituents.

The upshot of these many different types of regulation is that any intercompany debt obligation is likely to factor into multiple regulatory calculations -- and therefore limits -- with respect to entities within these U.S. financial services groups.

B. Regulatory Need for Intercompany Debt
While financial regulation aims to prevent excessive debt, at the same time regulators value and even mandate debt in certain parts of the capital structure of a financial services group because debt offers it flexibility that equity does not, and therefore can be used as a means to move capital and liquidity around the group in times of financial stress. In contrast to debt, equity in regulated subsidiaries is relatively inflexible because the payment of dividends or a return of capital generally requires the approval of the host-country regulator.20 This section describes some of the circumstances in which regulatory requirements incentivize or compel the use of intercompany debt.
1. Resolution Planning
Title I of the Dodd-Frank Act requires certain large bank holding companies, such as our top-tier parent entities, to submit resolution plans, commonly known as living wills, to the FDIC and Federal Reserve Board. Living wills describe how a bank holding company can be resolved in an orderly manner under the U.S. Bankruptcy Code in the event of failure. Alternatively, a regulated financial institution may be resolved under Title II of the Dodd-Frank Act via the Orderly Liquidation Authority. The FDIC has released a notice describing its preferred single point of entry strategy for a Title II resolution, and the Federal Reserve Board and the FDIC have issued guidance that encourages groups like us to adopt a similar single point of entry structure under our Title I living wills. Under a single point of entry resolution, the top-tier parent of a financial services group would either enter into a Chapter 11 bankruptcy or be placed into a Title II receivership by the FDIC. Whichever route is chosen, it is fundamental to the post-financial crisis regulatory toolkit for resolving a large financial institution without the need for taxpayer capital that the unsecured long-term debt of the holding company would bear losses and the operating subsidiaries would be recapitalized.

For this strategy to be effective, the bank holding company must issue enough unsecured long-term debt to absorb losses of its operating subsidiaries in the wake of financial stress. Consistent with the single point of entry strategy, in November 2015, the Federal Reserve Board issued a notice of proposed rulemaking to require banks like us to issue and maintain minimum levels of external "total loss-absorbing capacity" ("TLAC") and long-term debt. The Federal Reserve Board proposed rules that also would require large foreign banks to hold certain amounts of intercompany debt that may be used in the recapitalization of certain of their U.S. subsidiaries (internal total loss-absorbing capacity and long-term debt). The Federal Reserve Board is considering extending the internal total loss-absorbing capacity and long-term debt rules to domestic financial institutions, such as us. Moreover, the 2017 regulatory guidance for living wills issued by the Federal Reserve Board and the FDIC in April 2016 suggests that there may need to be some pre-positioning of loss-absorbing capacity at certain operating companies. Intercompany debt allows these groups to pre-position liquidity at subsidiaries that could be used in the event of financial stress; by using intercompany debt, the parent company would not have to rely on dividends to receive cash from its subsidiaries.

Foreign regulators will likely adopt similar rules. During the second half of 2016, the European Commission is expected to bring forward a proposal to implement the TLAC standards in the EU by 2019. This proposal is likely to take the form of a requirement to hold a higher minimum amount of "own funds and eligible liabilities" ("MREL"), building on the requirement in the EU Bank Recovery and Resolution Directive for all EU banks to maintain MREL.

2. Double Leverage
Even when the regulations do not require debt, regulators may prefer it in certain circumstances arising in the course of their prudential supervisory role. An example of this is the general disfavor toward high double leverage at banking subsidiaries.21 As discussed above, it is common for a parent company to raise cash in the capital markets by issuing debt and downstreaming this funding to its operating subsidiaries to meet their needs for cash. But the form in which it downstreams the funding matters greatly from a regulatory perspective. If the parent sends the cash down as a capital contribution, it will depend on the subsidiary's dividends to pay debt service to third party investors because the subsidiary must fund the parent's repayments of debt; that debt in essence becomes a call on its capital, a problem known as high double leverage. Moreover, equity in a non-U.S. subsidiary is subject to sovereign risk -- capital may be difficult to repatriate from a country in economic stress. By contrast, if the parent sends the cash down as a loan, the subsidiary must make periodic payments to its parent on the debt that do not require regulatory approval, the parent will have the benefit of creditor rights in distress, and its balance sheet will reflect the true liability.
3. Regulation K
The Federal Reserve Board's Regulation K places limits on a U.S.-regulated financial institution's individual and aggregate investments in equity and subordinated debt of non-U.S. subsidiaries, and a regulated financial institution may not make any investments exceeding these limits without the specific consent of the Federal Reserve Board. For example, a U.S. bank's investments in overseas affiliated subsidiaries would be subject to these limits.
4. Liquidity Requirements
Regulators are increasingly focused on liquidity issues, seeking to ensure that a banking organization's liquid assets are appropriate in relation to its potential liquidity needs, both on a consolidated and standalone basis. These liquidity requirements include both quantitative elements, such as the Liquidity Coverage Ratio ("LCR"),22 and qualitative elements, such as regulator expectations communicated through the resolution planning process. Importantly, these liquidity requirements consider both the consolidated and standalone liquidity positions of the parent and certain subsidiaries, ensuring that both the parent and its subsidiaries can access an appropriate amount of liquidity when and where it is needed.23 As a result, liquidity requirements incentivize banking groups to calibrate the maturity of internal funding mechanisms such that short-term, liquid assets held in subsidiaries are matched by similarly short-term internal funding to these subsidiaries, such as deposits and demand loans. Equity funding would not serve the liquidity management purpose, since equity -- being a form of permanent funding that, as discussed above, faces regulatory constraints on distributions -- would constrain the banking group's flexibility to manage liquidity throughout the group. For example, a bank, which is significantly funded by deposits and other short-term obligations, would impair its standalone liquidity position if it funded its subsidiaries with excessive amounts of equity capital. This is because any amount invested in a subsidiary's equity would be a long-term asset of the bank, and thus, while improving the subsidiary's liquidity position, would impair the bank's standalone liquidity position. Therefore, to the extent the host-country regulators allow it, a bank has an incentive to cause its subsidiaries to distribute excess capital up to the bank.
5. Summary of Regulatory Need for Intercompany Debt
In summary, a U.S. financial services group must satisfy multiple, sometimes competing regulatory imperatives that effectively dictate the amount and placement of intercompany debt. Most particularly, it needs to demonstrate that its capital structure will allow it to be resolved by a resolution authority in a stress situation, through a mix of prepositioned assets at subsidiaries and subsidiary debt held by upper-tier entities. Relatedly, it must reconcile the needs of its home-country regulators, which prefer debt to equity investments in subsidiaries because of equity's greater risk, with its host-country regulators' general preference for equity capital. These competing demands mean that every regulated subsidiary must use a calibrated blend of funding types to meet formulaic regulatory requirements and expectations: sufficient equity capital to meet local regulatory requirements, long-term debt to meet resolution planning requirements, and short-term debt to preserve the parent's and the group's flexibility and liquidity. In effect, these needs operate as tight parameters that essentially shape the group's capital structure and therefore the intercompany debt in the group.

These requirements have an effect not only on the initial capitalization of a subsidiary, but also the choice of how to deploy the subsidiary's profits. Leaving profits in the subsidiary or using the profits to pay down intercompany debt would, over time, skew the U.S. group's interest in the subsidiary in the direction of equity and away from debt. From the U.S. regulatory perspective, as described above, this would result in added risk within the U.S. group because the capital in the subsidiary would be "trapped." The group would have less flexibility in the event of financial stress. As a result, there is a general preference to return any excess capital to the U.S. in the form of distributions, whenever possible, while preserving the desired level of intercompany debt.

For a financial services group, regulatory compliance is critical, and the amount and placement of the group's debt is central to the regulatory framework. Meeting regulatory requirements takes precedence when debt is issued within the group.

 

III. Recommendations

 

In this Section III, we suggest modifications to the Proposed Regulations.
A. The Funding Rule Should Include an Exception for Regulated Financial Institutions
The Proposed Regulations should include an exception to the Funding Rule for regulated banks and broker-dealers. The tax policy concerns that motivated the Funding Rule are not present for these entities. And the effects of the Proposed Regulations on these entities are harsher, and more perverse, than on other types of businesses because of how financial services groups operate. In short, the marginal benefit to the tax system from curtailing the extremely limited tax planning that a regulated financial institution can do (if any) is vastly outweighed by the policy cost of both impeding its valid business practices and making financial services groups more fragile in times of financial stress, thereby creating risk to the financial stability of the United States.
1. The Funding Rule's Policy Concerns Are Not Implicated
The Funding Rule aims to curtail tax-motivated intercompany debt. The preamble to the Proposed Regulations describes a number of concerns regarding "excessive" intercompany debt that motivated Treasury and the IRS to issue the regulations. In proposing the Funding Rule, Treasury and the IRS further indicated that they were troubled by debt running between related parties because such debt often does not have a substantial non-tax business purpose and because there may be little non-tax significance to the creation of the debt instrument or the distinction between the debt instrument and equity. These policy concerns are not implicated when financial services groups use intercompany debt.

First, as outlined above, financial services groups use intercompany debt on a daily basis for clear and ordinary course business, not tax, reasons. This debt is not merely convenient; it is crucial to ordinary business operations. Debt that is downstreamed from the parent company, and refinanced periodically, serves a rational business and regulatory function that is consistent with good tax policy. Issuing debt from the parent company is efficient, and results in leverage at the operating subsidiaries that is reflective of the overall group's leverage. If anything, it would be irrational for the debt issued at the parent level not to be reflected in comparable debt at the operating subsidiaries' level. It would also give rise to regulatory concerns about double leverage and "trapped" capital, among other issues.

Second, the most frequent types of intercompany debt deployed within a financial services group, such as deposits and repos, do not resemble equity at all; they are the epitome of what tax lawyers and the IRS have historically viewed as debt.

Third, unlike companies in most other businesses, there are serious external consequences to the intercompany borrowing and lending that a regulated bank or broker-dealer does. Unlike the taxpayers referenced in the Proposed Regulations' preamble, these entities cannot create debt without affecting their businesses. As described above, they are regulated entities whose books are carefully scrutinized on a standalone basis. This scrutiny includes numerous quantitative tests set forth in black letter regulation, as well as, importantly, a variety of qualitative tests to ensure the aims of the regulatory mandate are achieved. In effect, the regulators function as vigilant third parties, ensuring that these entities are not leveraging themselves inappropriately. Regulatory capital requirements function as a mathematical limit on the debt-equity ratios of these entities. A financial services group operates within a regulatory and supervisory framework that infuses everything it can do.

The business of these entities depends on the market's perception of their creditworthiness, because every day depositors, customers and other counterparties make decisions about whether to transact with them based on their perceived financial health. As was shown in the 2008 financial crisis, any hint of concern about a financial entity's solvency can cause its creditors to withdraw their deposits or repo funding overnight.

2. Financial Groups are Disproportionately Affected by the Funding Rule
Although regulated banks and broker-dealers function outside of the stated concerns of the Funding Rule, the rule nevertheless hits those entities disproportionately. Making intercompany loans is fundamental to the ordinary course of a global financial services business. If intercompany debt were curtailed, these groups would be substantially harmed, and banking and broker-dealer subsidiaries on a standalone basis would have substantially increased risks and costs relating to liquidity, interest rates, and currency. As a result, if the Proposed Regulations were finalized in their current form, a financial services group would face the choice between, on the one hand, staggering administrative complexities and a tax burden disproportionate to its true economic profit, and on the other hand, the imposition of crippling constraints on its ordinary business activities. While another type of business might be able to avoid the harsh effects of the Proposed Regulations with careful planning, that is not true of financial services groups.

The Funding Rule, coupled with the sheer number of a financial services group's transactions, can quickly result in a tax liability that is fundamentally disconnected with any concept of taxable income as we know it. The "cascading" effect of the Funding Rule, which occurs when debt is converted into equity under the Funding Rule and is therefore treated as an acquisition by the lender of stock of the borrower or as paying "dividends" to the lender, in either case, causing other debt to be converted into equity, serves to exacerbate the adverse consequences to a financial services group of the Funding Rule.24 The effect is a tax burden that bears no connection to actual economic profit.

Another reason that financial services groups will not be able to avoid the harsh consequences of the Funding Rule is that they face regulatory constraints on their ability to control the timing of intragroup distributions. As discussed in Section II.B, resolution planning requires that firms balance keeping recapitalization resources at the top-tier parent or an intermediate holding company with pre-positioning at the subsidiaries so that those resources might readily be deployed to dynamically address unexpected losses at the subsidiaries. This necessitates distributing any excess capital upwards from subsidiaries to the top tier-parent entities or intermediate holding companies, thereby triggering the Funding Rule despite the distributions being strongly encouraged by regulatory, rather than motivated by tax planning, considerations. On the other hand, as previously described, host country regulators of non-U.S. subsidiaries of financial services groups often limit the ability of the subsidiaries to pay dividends, thereby resulting in pressure (which may come from U.S. regulators) for the subsidiaries to pay dividends in the windows when they are not so constrained. These subsidiaries lack the flexibility enjoyed by entities in industries that are not regulated to control the timing of dividends and are therefore more likely to trigger the Funding Rule even where the dividend is not motivated by tax planning considerations.

Because debt and leverage are so central to a financial services group's business, the consequences to it of the adverse treatment of debt under the tax law can be magnified and severe. The Proposed Regulations are no exception to this principle.

The Code and Treasury Regulations acknowledge that banks and broker-dealers are different from other types of businesses by treating them differently in a variety of contexts. In many cases, these rules treat borrowing, lending or paying or receiving interest by most taxpayers in an adverse manner, but in carving out financial entities recognize that such adverse treatment would harm the core activities of such an entity in a manner contrary to sound tax policy. Exempting regulated banks and broker-dealers from the Funding Rule would be consistent with provisions throughout the Code and Treasury Regulations that treat these entities differently from other business organizations. The tax law has consistently acknowledged the special nature of banks and broker-dealers when it comes to debt. The reasons to do so in this case are especially compelling.25

3. Proposal
In order to address the issues described above, we propose that Treasury and the IRS provide an exception to the Funding Rule for regulated banks and broker-dealers. Under our proposed exception, the Funding Rule would not apply to debt issued by a "qualified regulated entity." We define qualified regulated entity generally to include a bank or broker-dealer subject to specified U.S. regulatory regimes, as well as a comparable non-U.S. entity. Our proposed exception is outlined in Appendix A, which also includes a commentary providing further explanation of the general purpose of the proposed exception, as well as the rationale for the specific language employed in the proposal.
B. The Documentation Rule Should Permit Annual Credit Testing and Provide An Exception for Secured Lending
Banks and broker-dealers use a variety of financial instruments in the ordinary course of their business operations. The tax law treats some of these instruments as debt, even though they are not structured as debt in legal form and may not be treated as debt under non-tax principles. Examples include repos and similar transactions, upfront payments in notional principal contracts and other derivatives, and cash collateral that secures derivatives and securities loans. The Documentation Rule reserves on its application to instruments that are not debt in form.26 Treasury should provide that the Documentation Rule does not apply to these instruments. Documentation for these instruments generally differs from that used for legal form debt and these differences would make it difficult to comply with the mandates of the Documentation Rule.

Treasury should further revise the Documentation Rule in the following ways. First, the rule should provide that (1) master documentation agreements satisfy the documentation requirements of -2(b)(2)(iii); and (2) the expectation of repayment under such agreements may be tested annually rather than upon any issuance of a debt instrument. This modification would ease the rule's administrative burden on financial services groups that enter into frequent intercompany debt transactions and whose creditworthiness is tested on an ongoing basis for regulatory reasons. Second, the rule should provide relief from the borrower creditworthiness test for secured fundings, since a debt issuer's credit is less relevant to the likelihood of repayment in this context. Third, the rule should provide that documentation customarily used in comparable transactions with third parties satisfies the requirements of -2(b)(2)(i) and (ii). The use of pre-existing arm's length documentation serves Treasury's and the IRS's desire to ensure that debt is a legally enforceable obligation and the taxpayers' desire to minimize the rule's administrative burden.

Finally, Treasury should change the effective date of the rule so that it applies only to debt issued one year after the Proposed Regulations are finalized. Financial services groups will need to design and implement compliance programs to document their transactions on an automated basis in compliance with these new rules. Such groups will also need to conduct further analysis of whether existing bank and broker-dealer documentation that meets regulatory compliance standards satisfies the rule's requirements. In light of these concerns, we request more time to implement procedures to comply with the Documentation Rule.

 

IV. Conclusion

 

Debt is fundamental to the business and organizational structure of a financial services group. This is equally true of intercompany debt as it is of external debt. Intercompany debt in the context of financial services groups is driven by, and constrained by, business needs and regulatory requirements, not tax considerations. As a result, the concerns that motivated Treasury and the IRS to issue the Proposed Regulations do not apply to these entities. When combined with the harm that the Proposed Regulations will inflict on financial services groups in the form of either a disproportionate tax burden or disrupted business operations and greater risk, the lack of regulatory purpose militates strongly in favor of exempting these entities from the Funding Rule entirely and modifying the Documentation Rule to make compliance more feasible as a practical matter.
Respectfully submitted,

 

 

Citigroup Inc.

 

 

Bank of America Corp.

 

 

JPMorgan Chase & Co.

 

Cc:

 

Emily S. McMahon

 

Deputy Assistant Secretary (Tax Policy)

 

Department of the Treasury

 

 

Robert B. Stack

 

Deputy Assistant Secretary (International Tax Affairs)

 

Department of the Treasury

 

 

Danielle E. Rolfes

 

International Tax Counsel

 

Department of the Treasury

 

 

Douglas L. Poms

 

Deputy International Tax Counsel

 

Department of the Treasury

 

 

Brenda L. Zent

 

Special Advisor

 

Office of International Tax Counsel

 

Department of the Treasury

 

 

Kevin C. Nichols

 

Senior Counsel

 

Office of International Tax Counsel

 

Department of the Treasury

 

 

Thomas C. West, Jr.

 

Tax Legislative Counsel

 

Department of the Treasury

 

 

Krishna P. Vallabhaneni

 

Deputy Tax Legislative Counsel

 

Department of the Treasury

 

 

Ossie Borosh

 

Senior Counsel

 

Office of Tax Legislative Counsel

 

Department of the Treasury

 

* * * * *

 

 

APPENDIX A

 

 

Proposed Exception for Qualified Regulated

 

Entities27

 

 

Add Proposed Section 1.385-3(f)(4) to read as follows:

(4) Exception for qualified regulated entities. Paragraph (b)(3) of this section does not apply to a debt instrument issued by a qualified regulated entity.

Add Proposed Section 1.385-3(f)(12) to read as follows:

(12) Qualified regulated entity. -- (i) General rule. The term qualified regulated entity means any of the following entities:

 

A. A bank (as defined by section 2(c) of the Bank Holding Company Act of 1956 (12 U.S.C. 1841(c)), without regard to subparagraphs (C) and (G) of paragraph (2) of such section);

B. A person that is registered as a securities broker or dealer under section 15(a), a security-based swap dealer under section 15F(a), or a Government securities broker or dealer under section 15C(a), of the Securities Exchange Act of 1934;

C. A person that is registered as a swap dealer under section 4s, or as a futures commission merchant under section 4d, of the Commodity Exchange Act;

D. A non-U.S. person that satisfies the following requirements:

 

1. It is engaged in the active conduct of a banking business, and conducts substantial activities with respect to that business within the meaning of section 954(h)(2)(A)(ii), in the jurisdiction in which it is chartered, incorporated, or organized, or is a regular dealer for purposes of section 954(c)(2)(C), and conducts substantial activity in relation to its business as a regular dealer, in the jurisdiction in which it is chartered, incorporated, or organized;

2. It is licensed or authorized in the country in which it is chartered, incorporated, or organized to conduct a banking, securities or derivatives business with customers that are residents of that country; and

3. It is subject to bona fide regulation, including appropriate reporting, monitoring, and prudential (including capital adequacy) requirements, by a financial regulatory authority in that country that regularly enforces compliance with such requirements and prudential standards.

 

(ii) Special rules.

 

A. An entity will not be considered a qualified regulated entity if the Commissioner determines that one of the principal purposes for the entity's formation, acquisition or licensing was to obtain the benefits of qualified regulated entity status.

B. A debt instrument issued by a legal entity that is classified as a partnership or disregarded entity will be treated as issued by a qualified regulated entity only if the issuer would be classified as a qualified regulated entity if it were treated as a separate corporation.

Commentary on the Proposal

 

 

1. Purpose and rationale.

 

This qualified regulated entities exception would provide a limited exception for regulated banks and securities and derivatives dealers that meet carefully-delineated requirements. The beneficiaries of the exception are subject to regulation that encompasses every aspect of their capital structure: the manner in which they raise and use funds; the amount of liquidity they are required to maintain; and the terms, timing and amount of intragroup funding transactions and distributions. In the absence of an exception, there could be severe (and potentially irreconcilable) tensions between these financial regulatory requirements and the operation of the Proposed Regulations.

The exception is intended to provide relief from those tensions in circumstances where extensive independent safeguards prevent regulated entities from engaging in the conduct targeted by the Proposed Regulations.

 

2. Sentence-by-sentence analysis.

 

a. Domestic entities.
In order to qualify for the benefit of the exception,
  • a U.S. bank must be a bank as defined in section 2(c) of the Bank Holding Company Act of 1956 without regard to subparagraphs (C) and (G) of paragraph (2) of that section;

  • a U.S. securities dealer must be registered as a securities broker or dealer under section 15(a), a security-based swap dealer under section 15F(a), or a Government securities broker or dealer under section 15C(a), of the Securities Exchange Act of 1934; and

  • a U.S. derivatives dealer not otherwise covered by the preceding bullets must be registered as a swap dealer under section 4s, or as a futures commission merchant under section 4d, of the Commodity Exchange Act.

 

Comment: Proposed Sections 12(i)(A), (B) and (C) derive their language from existing provisions in the Internal Revenue Code. Specifically, Proposed Section 12(i)(A) is derived from Section 956(c)(2)(A), which is designed to limit the benefit of the Section 956 deposit exception to fully licensed banks and was enacted to reverse the result in The Limited, Inc. v. Commissioner, 286 F.3d 324 (6th Cir. 2002).28 Proposed Section 12(i)(B) is derived from Section 954(h)(2)(B)(iii), which limits the active financing exception under Section 954(h) to certain registered securities dealers, among others; and Section 901(k)(4)(A), which provides an exception from the disallowance of certain foreign tax credits with respect to dividends received by certain registered securities dealers. In addition, we have added language to Proposed Section 12(i)(B) to extend its application to registered security-based swap dealers and have added Proposed Section 12(i)(C) to extend the exception to registered swap dealers and futures commission merchants. Regulatory oversight of these entities justifies their exclusion from the application of the Proposed Regulations.
b. Foreign entities.
In order to qualify for the benefit of the exception, a foreign bank or dealer in securities or derivatives must satisfy an activities-based test, a licensing test and a regulation-based test.29

In order to satisfy the activities-based test,

  • A foreign bank must be engaged in the active conduct of a banking business, and must conduct substantial activities with respect to that business within the meaning of section 954(h)(2)(A)(ii), in the jurisdiction in which it is chartered, incorporated, or organized, and

  • A foreign dealer must be a regular dealer for purposes of section 954(c)(2)(C) and must conduct substantial activity in relation to its business as a regular dealer in the jurisdiction in which it is chartered, incorporated, or organized.

 

Comment: Proposed Section 12(i)(D) is derived from rigorous and detailed requirements that foreign banks and dealers in securities and derivatives must satisfy in order to qualify for the active financing exception under Section 954(h) and the dealer exception under Section 954(c)(2)(C).

The requirement that a qualified regulated entity conduct substantial activities in its home country is designed to make the exception available only to genuinely active businesses, and to ensure that "nameplate" or "turnkey" operations do not qualify.

The legislative history to Section 954(h) provides a list of quantitative and qualitative factors that may be taken into account for purposes of defining "substantial activity," including an entity's overall size, the amount of its revenues and expenses, the number of its employees, the ratio of its revenues per employee, the amount of property it owns, and the nature, size, and relative significance of its activities conducted.30 In addition to incorporating the Section 954(h)(2)(A)(ii) substantial activity requirement for banks, we have included a substantial activity requirement for dealers, as well as a separate "home country" requirement for both banks and dealers.

In order to satisfy the licensing and regulation-based tests, a foreign bank or dealer must be:

  • Licensed or authorized in the country in which it is chartered, incorporated, or organized to conduct a banking, securities or derivatives business with customers that are residents of that country; and

  • Subject to bona fide regulation, including appropriate reporting, monitoring, and prudential (including capital adequacy) requirements, by a financial regulatory authority in that country that regularly enforces compliance with such requirements and prudential standards.

 

Comment: Proposed Sections 12(i)(D)(2) and (3) are derived from the conditions that regulated securities dealers must satisfy under Treasury Regulation § 1.954-2(a)(4)(v)(B)(2) and Section 901(k)(4)(A)(iii). Regulatory guidance has not been provided with respect to the comparable rules applicable to banks under Section 954(h). The licensing and regulatory requirements applicable to securities dealers are thoughtful and complete; the proposal adopts the same formulation for banks and derivatives dealers.

These tests are designed to exclude entities that do not conduct substantial activities in their home countries, or that are subject to inadequate regulatory regimes. They require, in particular, that a bank or dealer must be licensed or authorized to do business with customers that are resident in its home country and be subject to prudential requirements that are actually enforced by a local regulator.

c. Special rules.
The proposal includes two special rules:
  • Anti-abuse rule. The IRS would have the authority to deny the benefit of the exception if it "determines that one of the principal purposes for the entity's formation, acquisition or licensing was to obtain the benefits of qualified regulated entity status."

 

Comment: The qualified regulated entities exception as a whole has been drafted with the objective of ensuring that the exception has a limited scope, and is available only to its intended beneficiaries: substantial banks and dealers that are subject to rigorous financial regulation effectively addressing essentially the same issues and concerns that motivated the Proposed Regulations.

We expect that most (and perhaps all) of the entities that would qualify for the exception would be members of groups that are subject to rigorous financial regulation at multiple levels in multiple countries. We do not believe these proposals would apply to a special-purpose "bank," "securities dealer" or "derivatives dealer" formed in order to benefit from the exception.

We have nevertheless included an anti-abuse rule for three reasons: (i) as a precaution against unforeseen applications of the exception; (ii) to give Treasury and the IRS the ability to challenge inappropriate use of the exception; and (iii) to discourage taxpayers from engaging in abusive transactions.

  • Partnerships and disregarded entities. The exception would be available in respect of instruments issued by an entity that is treated as a partnership or disregarded entity for U.S. federal income tax purposes only if the entity would have qualified for the exception if it had been a separate corporation.

 

Comment: Proposed Section 12(ii)(B) is intended to serve two purposes. First, it confirms that a regulated entity cannot rely on the exception in respect of instruments issued by a subsidiary that is treated as a separate entity for foreign regulatory purposes but is treated as a partnership or disregarded entity for U.S. federal income tax purposes. Second, it provides that instruments issued by a regulated entity can, under appropriate circumstances, qualify for the exception even if the entity is a partnership or disregarded entity for U.S. tax purposes.

 

FOOTNOTES

 

 

1 Unless otherwise stated, all section references are to the Code or the Treasury Regulations thereunder.

2 Prop. Treas. Reg. §§ 1.385-3, 1.385-4 (to the extent consolidated group transactions are relevant).

3 Prop. Treas. Reg. § 1.385-2.

4 As used herein, the term "broker-dealer" refers not only to a securities broker-dealer, but also to a swaps or other derivatives broker or dealer, in each case, that is regulated under applicable U.S. or foreign regulatory regimes and that is a subsidiary of a bank holding company, since many of the concepts discussed in this letter apply similarly among these regulated entities.

5 We also see merit in alternatives proposed by our industry trade associations, including the recommendation by the Securities Industry and Financial Markets Association ("SIFMA") that the Funding Rule not apply to regulated financial groups. In addition, we are aware of proposals to except transactions between controlled foreign corporations from the Funding Rule and believe such an exception, if properly structured, could be helpful and appropriate.

6 For example, Citigroup Inc., together with its subsidiaries ("Citi"), derives approximately 50% of its revenue from outside the United States and is physically present in approximately 100 countries, many of which it has been in for over 100 years. See Citi 2015 Annual Report, at 13. Across the countries in which JPMorgan Chase & Co. and its subsidiaries ("JPM") operate, roughly 40% of its business consists of local transactions and 60% of its business consists of either outbound or inbound transactions. See JPM 2015 Annual Report, at 17.

7 For example, Bank of America Corp.'s (together with its subsidiaries, "BofA") principal U.S. broker-dealer subsidiaries are Merrill Lynch, Pierce, Fenner & Smith Incorporated, Merrill Lynch Professional Clearing Corp., and Merrill Lynch Capital Services, Inc., and its significant non-U.S. broker dealer subsidiaries include Merrill Lynch International and Merrill Lynch Japan Securities Co., Ltd. See BofA July 1, 2015 Corporate Resolution Plan (https://www.fdic.gov/regulations/reform/resplans/plans/boa-165-1507.pdf).

8 Leverage refers to the extent to which an organization uses debt to finance its assets or exposures. There are several ways to measure leverage. An institution with a leverage multiple of 10:1 uses $1 of equity (and $9 of debt) for every $10 of assets. In the bank regulatory context, a leverage ratio is the ratio of a banking organization's capital (generally, its equity plus other loss-absorbing instruments, subject to certain adjustments) to a measure of its assets or exposures that is not weighted for the riskiness of the assets or exposures (such as total consolidated assets). See 12 C.F.R. § 217.10(b).

9See, e.g., Michael Brei & Leonardo Gambacorta, The Leverage Ratio Over the Cycle, Bank for International Settlements Working Papers, Nov. 2014.

10 Our primary source of external debt funding is the deposits we take in through our banking subsidiaries and branches worldwide. These deposits are our most stable and lowest cost source of long-term funding. Deposits represent over $900 billion out of approximately $1.5 trillion of Citi's third-party liabilities, over $1.2 trillion of JPM's $2.1 trillion third-party liabilities and over $1.1 trillion of BofA's $1.8 trillion third-party liabilities. Our other major sources of funding were stockholders' equity (Citi -- $221 billion; JPM -- $247 billion; BofA -- $256 billion), long-term debt (Citi -- $201 billion; JPM -- $288 billion; BofA -- $236 billion), and repurchase transactions (Citi -- $146 billion; JPM -- $152 billion; BofA -- $174 billion) (numbers are approximate as of 12/31/15). See Citi 2015 Annual Report, at 133; JPM 2015 Annual Report, at 178; BofA 2015 Annual Report, at 133.

11See, e.g., Citi 2015 Annual Report, at 90.

12 The following description also applies to our swap dealers that are banks.

13See also Section II.B below, describing regulatory mandates that effectively require us to balance the duration of assets and liabilities of each of our banking and broker-dealer subsidiaries.

14 In the United States, only certain entities -- generally, U.S. depository institutions, U.S. branches of foreign banks and certain other eligible entities -- are permitted to open an account with a Federal Reserve Bank. See Federal Reserve Banks Operating Circular 1, 1-2 (Feb. 1, 2013).

15See generally 12 C.F.R. part 217. The U.S. Basel III rules implement in the United States the framework of capital standards published by the Bank for International Settlements' Basel Committee on Banking Supervision and known as the Basel III capital accord. Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems (June 2011 rev.).

16 This statement is based on the lesser of each company's common equity tier one capital ratio under the standardized approach on the one hand and the advanced approaches on the other, in each case based on ratios as reported to the Federal Reserve Board. See Regulatory reporting data in the Bank Holding Company Performance Report as of Mar. 31, 2016 (BofA: 11.58% standardized, 10.25% advanced; Citi: 14.79% standardized, 14.04% advanced; and JPM: 12.07% standardized, 11.85% advanced).

17 In addition, as discussed above and below, broker-dealers that are part of large banking organizations are indirectly subject to requirements applicable to their holding company parent, such as consolidated capital requirements that effectively limit their use of leverage, and to resolution planning requirements that drive a need for intercompany debt.

18 FCMs are similarly subject to net capital requirements. Swap dealers that are also banks prudentially regulated by a banking regulator must comply with the capital requirements already applicable to them as banks. While the specific capital requirements for non-bank swap dealers that are not also FCMs (such as Citigroup Energy Inc.) have not yet been finalized, these entities will be subject to regulatory capital requirements.

19 While all of the regulatory consequences to banks of the U.K.'s anticipated departure from the EU are not yet known, we do not expect that it will affect the obligation to comply with Basel III.

20See, e.g., BofA 2015 Annual Report, at 59 ("Liquidity held in another regulated entity is primarily available to meet the obligations of that entity and transfers to the parent company or to any other subsidiary may be subject to prior regulatory approval due to regulatory restrictions and minimum requirements.").

21 Double leverage is generally the ratio of parent company equity investments in subsidiaries to parent company equity. It measures the degree to which equity investments in subsidiaries are financed by debt issued by the parent company. A high double leverage ratio may indicate that the parent company is relying too much on dividends from its subsidiaries as a payment source for its liabilities.

22 12 C.F.R. part 249. Under the LCR requirement, banking organizations (including bank holding companies and their banking subsidiaries) must hold certain types of liquid assets in an amount at least equal to the organization's projected net cash outflows over a standardized 30-day period of hypothetical financial stress.

23 Although the LCR requirements are generally calculated on a consolidated basis, the LCR rule imposes limitations on a parent's ability to recognize certain excess liquidity maintained in its subsidiaries, effectively requiring banking organizations to calculate each subsidiary's LCR on a standalone basis.

24 While the cascading effect amplifies the consequences of the Funding Rule to a financial services group, even without this amplification the consequences are so severe that the relief we are seeking is needed even were the Proposed Regulations revised to eliminate the cascading effect.

25 The closest parallel in the Code is the treatment under Section 956 of certain intercompany obligations involving banks and dealers in securities or commodities. While, in general, Section 956 gives rise to subpart F income if a controlled foreign corporation holds debt of a U.S. related party, it exempts certain bank deposits; cash or securities paid or received in the ordinary course of business by a securities dealer as collateral or margin for securities loans, derivatives and other financial transactions; readily marketable securities sold or purchased under a repo or otherwise posted or received by a securities dealer in the ordinary course of business; and securities held in the ordinary course of business by a securities dealer for sale to customers. The legislative history evidences Congressional intent to exempt "normal commercial transactions." H.R. Rep. No. 87-1447, at 65 (1962); Sen. Rep. No. 87-1881, at 88 (1962).

However, Section 956 is only one of many examples in which Congress or Treasury has singled out banks or securities dealers for special treatment. See also Section 279(c)(5) (addressing convertible debt issued by leveraged corporations for acquisitions), Treasury Regulations under Section 882 of the Code (addressing the amount of interest expense a foreign corporation may treat as allocable to income effectively connected with its U.S. business), Section 954(c)(2)(C) and 954(h) (treating certain interest income of dealers and banks as non-subpart F income) and Section 1297(b)(2)(A) (treating certain income derived in the banking business as active for purposes of determining whether an entity is a passive foreign investment company).

26 Prop. Treas. Reg. § 1.385-2(a)(4)(i).

27 "Proposed Section" references are to the qualified regulated entities exception described herein.

28See H.R. Rep. 108-755, at 637 (2004) (Conf. Rep.); H.R. Rep. 108-548, at 295 (2004).

29 Foreign entities may alternatively qualify under Proposed Sections 12(i)(B) or (C) if they meet the requirements in the relevant section.

30See H.R. Rep. 105-825, at 1559 (1998) (Conf. Rep.).

 

END OF FOOTNOTES
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