HSBC Pushes for Financial Group Exception in Debt-Equity Regs

HSBC North America Holdings Inc. ("HNAH"), on behalf of itself and its parent company, HSBC Holdings plc, and its affiliates worldwide (collectively, the "HSBC Group"), appreciates the opportunity to provide comments on the recent notice of proposed rulemaking (REG-108060-15) and the proposed regulation under Section 385 of the Internal Revenue Code concerning the treatment of certain corporate instruments as stock or indebtedness (the "Proposed Regulations").¹

I. Summary

The HSBC Group recognizes the important role that the Proposed Regulations can serve in addressing tax policy concerns regarding the potential earnings stripping impact of excessive related party debt, particularly in cases when such debt lacks meaningful non-tax significance. Similarly, we recognize the value of imposing discipline on the legal documentation and economic analysis supporting the characterization of an instrument as indebtedness for US tax purposes.

However, if finalized as drafted, the Proposed Regulations will result in the inequitable and inappropriate tax treatment of debt arising in the normal day-to-day commercial US operations of Foreign Banking Organizations ("FBOs"), including debt instruments issued by financial institutions as mandated by prudential regulation. The result would be largely uncontrollable tax costs rendering normal commercial activity uneconomic and unadministrable, with costly and unnecessary compliance rules.

Financial institutions are different in critical ways from non-financial institution taxpayers. The unique commercial and regulatory characteristics mean that earnings stripping and other tax avoidance concerns that the Proposed Regulations are intended to address are not present in the context of financial institutions.

• The unique characteristics of financial institutions have previously been recognized by Congress, the Treasury Department, and the Internal Revenue Service by excluding them from the scope of various earnings stripping rules and similar provisions. These unique characteristics should similarly inform any decision regarding the application of Section 385 and the Proposed Regulations to financial institutions.²

• Borrowing and lending are the core commercial activities of financial institutions, and ordinary course banking activity with affiliates, particularly funding activity, is an essential and integral part of an FBO's global operating model. These activities include financial intermediation in the form of borrowing (including deposit taking) and lending operations, as well as dealer activities related to securities loans, repos, notional principal contracts, posted cash collateral, and other financial and market making activities. In performing these activities, interest expense is the equivalent of "cost of goods sold" of a manufacturer. The denial of a tax deduction for such a critical operating expense as a result of the recharacterization of a related party loan as equity under the Proposed Regulations is the equivalent of denying a manufacturer a tax deduction for the cost of raw materials consumed in the production process, essentially imposing income tax on gross sales receipts. Furthermore, any recharacterization will result in a mismatch in the tax treatment of interest between the impacted related parties, i.e. taxable interest income for the related lender and non-deductible interest expense for the US borrower.

• The capital and funding structure of financial institutions is governed by prudential regulation including, in the case of FBOs, the requirement for certain long-term debt to be issued to related parties. Adherence to this prudential regulation is enforced through a significant and comprehensive process of regulatory oversight. The objective of this prudential regulation is to ensure the maintenance of equity sufficient to assure the safety and soundness of financial institutions and the wider financial system in which they operate. The regulatory objective is aligned to the policy objective of the Proposed Regulations to ensure that for related-party debt instruments to be respected as such for tax purposes, they must have a substantial non-tax business purpose and substantial non-tax effects.

• Because the terms and amount of certain long-term debt issued by banking groups are mandated by prudential regulation, there are good policy reasons for ensuring that it is not recharacterized as equity for tax purposes, recognizing the unique regulatory framework applying to financial institutions. This form of debt is costly and is required as an implementation of regulatory policy intended to ensure that financial institutions are appropriately and adequately capitalized and to facilitate the orderly resolution of issuers of these securities with minimal harm to markets and taxpayers of any such resolution. The debt is not structured or intended to facilitate any type of tax avoidance, and there are sound policy reasons for respecting such instruments as debt for US tax purposes, which align with the regulatory policy requiring such instruments.

Specifically, Section II provides an overview of the HSBC Group in the U.S. and context regarding its activities and the regulatory environment in which it operates. Section III summarizes the particular challenges of the Proposed Regulations for the HSBC Group and other banking organizations; and Section IV details suggested recommendations for modification of the Proposed Regulations to address those challenges.

II. Overview -- HSBC's US Operations

HNAH is the common parent corporation of a consolidated group of entities operating in the United States (the "HNAH Group").⁵ At year end December 31, 2015, the HNAH Group had assets of US $271.9bn (US GAAP). The HNAH Group's businesses serve customers in the following key areas: retail banking and wealth management, commercial banking, private banking, and global banking and markets. HNAH's wholly owned, indirect subsidiary HSBC Bank USA, National Association, with total assets of US $183.1bn as of December 31, 2015 (US GAAP), serves 2.4 million customers through its operations and maintains more than 229 bank branches throughout the United States, including over 145 in New York as well as branches in: California; Connecticut; Delaware; Washington, D.C.; Florida; Maryland; New Jersey; Pennsylvania; Virginia; and Washington. Other significant US subsidiaries include HSBC Securities (USA) Inc., a registered broker dealer, HSBC Finance Corporation, a holding company for the runoff consumer finance operations, and HSBC Technology & Services (USA) Inc., a provider of information technology and centralized operational and support services.

HNAH is an indirect, wholly-owned subsidiary of HSBC Holdings plc ("HSBC Holdings"), a holding company organized in the United Kingdom. The HSBC Group is one of the world's largest banking and financial services organizations operating through banking organizations in 71 countries and territories.⁶ Because of the size of the US operations of the HSBC Group, it is required to hold its US subsidiaries through an intermediate holding company (an "IHC") which is subject to US bank regulatory supervision on a consolidated basis. HNAH is the IHC of the HSBC Group in the US. Because the HNAH Group is required to be organized under an IHC, it is not a candidate for inversion type transactions with respect to its US operations.

The HNAH Group's operations are geographically focused on the US, with no material overseas branches. Unlike many other FBOs, the HNAH Group does not maintain any US branches of its foreign banking affiliates. Any US resolution would be entirely contained locally.

The HNAH Group routinely engages in a wide variety of related party transactions that may be viewed as "debt" subject to recharacterization under the Proposed Regulations. Similar to the US operations of other FBOs, and as is thoroughly described in the IIB Letter, the core commercial activities of the HNAH Group primarily involve financial intermediation in the form of borrowing (including deposit taking) and lending operations, as well as dealer activities related to securities loans, repos, notional principal contracts, posted cash collateral, and other financial and market making activities.

Services related to these core activities are offered to third party customers as well as related parties, and involve a tremendous volume of transactions -- both in terms of dollar volume and number of transactions. The aggregate value of related party activity amounts to billions of dollars annually in the course of many thousands of separate transactions.

In performing these activities, interest expense for the HNAH Group is the equivalent of "cost of goods sold" of a manufacturer. The denial of a tax deduction for such a critical operating expense as a result of the recharacterization of a related party loan as equity under the Proposed Regulations is the equivalent of denying a manufacturer a tax deduction for the cost of raw materials consumed in the production process, essentially imposing income tax on gross sales receipts. Furthermore, any recharacterization will result in a mismatch in the tax treatment of interest between the related parties, i.e. taxable interest income for the related lender and non-deductible interest expense for the US borrower.

Because of the number and frequency of ordinary course related party funding transactions entered into by the HNAH Group, the potential "cascade" effects arising from the termination/repayment of funding transactions being recharacterized as distributions (in turn causing further related party funding transactions to be recharacterized and so on) are uniquely magnified.

In summary, these transactions are core banking activities, and are effected on terms similar to those entered into with any third party. Because of the nature of these ordinary course transactions, and the frequency and magnitude of these transactions, the potential effects of subjecting these transactions to recharacterization under the Proposed Regulations would severely and unfairly impact financial institutions such as the HNAH Group. These impacts would be extreme in terms cost and compliance burdens as compared to other industries.

The HNAH Group is not able to choose its capital structure; instead, it is mandated by the regulatory framework that imposes minimum levels of capital -- both equity and certain forms of debt -- intended to ensure the safety and soundness of the financial institution and, more broadly, of the US financial system.⁷ This framework includes requirements to carry out detailed stress testing to ensure the sufficiency of capital during periods of significant losses.

Rather than permit earnings stripping the FRB strictly regulates an institution's minimum capital levels, including limitations on any distribution that would reduce such capital (even if the bank is still well capitalized within regulatory requirements). Therefore, the regulatory environment in which financial institutions such as the HNAH Group operate (under the oversight of the FRB and other regulators), already polices the earnings stripping concern that the Proposed Regulations are intended to address. In addition to strictly monitoring compliance with minimum capital levels, the FRB also limits the leverage and liquidity of a banking group for similar reasons, including limits on funding concentration.

Furthermore, with particular regard to FBOs such as the HSBC Group, the regulatory framework increasingly imposes requirements for long term debt instruments to be issued to related parties when previously issuance to the local external market was permitted and preferred.⁸

The capital plan submitted to the FRB for review as part of the CCAR process includes not only the components of the HNAH capital structure, but also any planned capital actions such as dividends and issues, and planned repurchases of equity and debt. Under the CCAR process, the FRB reviews HNAH's capital plan, which includes projected sources and uses of funds, funding as required by applicable FRB rules, and proposed distributions, if any, under several different "normal" and stressed scenarios. The FRB assesses HNAH's overall financial condition, risk profile, and capital adequacy on a forward looking basis (quantitative assessment) and the strength of its capital planning process, including its capital policies (qualitative assessment). The FRB requires that HNAH's capital planning adequately accounts for the potential for economic and financial stressful environments and, in addition, the FRB also runs its own capital analysis based on HNAH data using a further, severely adverse stress scenario. HNAH must pass CCAR qualitatively (governance etc.) and quantitatively (capital ratios in excess of regulatory minimums) in order to effect capital actions, such as making a distribution.

It should also be noted that the FRB's objective in reviewing and approving the capital plan of any banking institution is to ensure that the institution meets minimum capital requirements that have increased significantly over the last several years. For example, US banks are now required to hold an amount of equity which is significantly higher -- in terms of absolute amount and in quality -- now as before the financial crisis.

Under the FRB's TLAC proposal released in October 2015, HNAH would be required to maintain a minimum level of TLAC, including a minimum level of Internal TLAC Debt. As an IHC, HNAH would be required to hold a minimum amount of TLAC not less than the greater of: (a) 18 percent of the covered IHC's total risk-weighted assets ("RWAs");⁹ (b) 6.75 percent of the covered IHC's total leverage exposure (if applicable); and (c) 9 percent of the covered IHC's average total consolidated assets, as computed for purposes of the US tier 1 leverage ratio. A portion of HNAH's TLAC must be in the form of Internal TLAC Debt with terms including a contractual conversion clause, subordination, and extremely limited acceleration rights. Under the proposed FRB rules, HNAH would be required to issue a substantial amount of Internal TLAC Debt equal to 7% of its RWAs to HSBC Holdings between now and full implementation in 2019.¹⁰ In contrast to IHCs, US G-SIBs are permitted to issue their TLAC debt externally, and without the contractual conversion and other restrictive terms.

III. Challenges Presented by the Proposed Regulations¹¹

Because of the frequency and magnitude of these ordinary course transactions, the potential effects of subjecting these transactions to recharacterization either under the documentation rules of Prop. Treas. Reg. § 1.385-2 or the general and funding rules of Prop. Treas. Reg. § 1.385-3 would severely and unfairly impact financial institutions such as the HNAH Group. These impacts would be extreme in terms cost and compliance burdens as compared to other industries.

The ordinary course transactions described above are undertaken by the HNAH Group on terms similar to those entered into with any third-party. In addition, these transactions are fundamental to the operation of a banking institution and are integral to the borrowing and lending of money that are the business of a banking group. These are not transactions which are structured to achieve earnings stripping results, and from a practical standpoint, they would be impossible to document and track as would be required by the Proposed Regulations.

No tax policy objective would be served by imposing the requirements of the Proposed Regulations on these transactions and we therefore respectfully suggest that activities of regulated financial groups be exempted from the application of the Proposed Regulations.

B. The Impact of the Funding Rule on Ordinary Course Transactions and Regulatory Instruments Issued in Debt Form

As noted in Section II.B.l above, a financial institution's ability to make distributions to its parent is subject to regulatory approval, and is largely driven by the institution's minimum levels of regulatory capital required by the FRB as measured under baseline and projected severely adverse stressed conditions.

Due to the determination of minimum capital levels by reference to RWAs, financial organizations such as the HNAH can generate excess capital in the absence of earnings, either current or cumulative, as a result of certain strategic decisions. For instance, to "de-risk" its balance sheet HNAH has actively reduced the amount of certain loan assets which are deemed to be of a higher risk profile, thus reducing RWAs. As noted above, any distribution of capital generated in this manner would require the approval of the FRB as part of the HNAH Group's capital plan.

Under the "Funding Rule" of Prop. Treas. Reg. § 1.385-3(b)(3), any distribution by the HNAH Group which is approved in light of regulatory minimum capital requirements, but is in excess of current earnings and profits, will result in the per se recharacterization of related party debt and generate an additional tax cost in the form of a lost deduction for interest paid on such related party borrowings. This recharacterization could apply to any related party borrowings, including those arising in the ordinary course of business or issued under prudential regulations, such as Internal TLAC Debt. The significant amount of related party debt maintained by the HNAH Group will likely ensure that there is always available debt to be recharacterized.

Given the regulatory scrutiny around the distribution of capital, and the incentives of banking regulators to limit such distributions in order to ensure the safety and soundness of the US financial system, any such distribution does not reflect the profile of a "funded distribution" structured and undertaken with the intent to move earnings to the foreign parent. Instead, the reason for such distributions would be to redeploy capital in a more economically advantageous manner as and when no longer required to support assets and operations of the HSBC Group's US global banking operations.

We therefore respectfully suggest that financial organizations should be excepted from the application of the "Funding Rule" of the Proposed Regulations so that any approved distribution are not treated as a basis for the per se recharacterization of related party debt (whether regulatory or arising in the ordinary course of business) of such organizations.

Notwithstanding the common law position, as drafted, the Proposed Regulations would likely make it impossible to characterize the Internal TLAC Debt as debt. Because of the contractual conversion feature, issuers could not satisfy Prop. Treas. Reg. § 1.385-2(b)(2)(i) which requires documentation that as of the date of issue, ". . . the issuer has entered into an unconditional and legally binding obligation to pay a sum certain. . . ." Similarly, due to the lack of acceleration rights, the terms of Internal TLAC Debt would likely make it impossible to demonstrate that the holder of the Internal TLAC Debt has the rights of a creditor to enforce the obligation or that it has superior rights to shareholders to share in the assets of the issuer in the case of dissolution as required by Prop. Treas. Reg. § 1.385-2(b)(2)(ii). As a result, Internal TLAC Debt would be recharacterized, resulting in no tax deduction for payments made on such debt in addition to other potential collateral consequences.

Similar to the US, banking regulations in other jurisdictions require the issuance of long term debt instruments; in some cases the instruments include "bail-in" or conversion provisions similar to Internal TLAC Debt. Several of these countries have either changed or clarified their law in order to permit issuers to respect such regulatory instruments as debt for local tax purposes. Examples of countries which have clarified or amended their law in this way include the United Kingdom, Hong Kong, and Germany, among others.

Because the terms and amount of Internal TLAC Debt are mandated to the HNAH Group, there are good policy reasons for ensuring that it is not recharacterized as equity, either under common law principles or by operation of the Proposed Regulations. Internal TLAC Debt, issued as an implementation of regulatory policy, and as a result of required terms, will be costly financing for issuers such as the HNAH Group. This form of debt would not be issued other than for regulatory purposes and is not structured or intended to permit any type of tax avoidance.

Further, because US G-SIBs are permitted to issue TLAC debt externally and without the troublesome terms described above, their TLAC debt will not be subject to recharacterization and the economics of such debt will not be impacted by the non-deductibility of payments thereon, as would be the case for Internal TLAC Debt. The FRB does, however, have the ability to convert external TLAC if required under resolution proceedings. Therefore, Internal TLAC Debt and external TLAC debt serve the same purpose from a resolution perspective. The fact that the conversion feature is included in the terms of Internal TLAC Debt, and is operative through regulatory powers in the case of external TLAC should not be a basis for inconsistent treatment of the instruments under the Proposed Regulations.

We therefore respectfully suggest that the Proposed Regulations be used to establish a safe harbor, confirming that instruments of indebtedness issued pursuant to and in compliance with prudential regulatory requirements, which would include Internal TLAC Debt, will be characterized as debt for US tax purposes.

IV. Detailed Recommendations

The HNAH Group respectfully makes the following recommendations for modification of the Proposed Regulations to address the challenges described above:¹²

² For example, the earnings stripping rules of Section 163(j) apply to net interest expense only. Because financial institutions are typically in a net interest income position (i.e. because interest expense is their "cost of goods sold"), the rules of Section 163(j) do not apply to them. In addition, qualified active financial income is exempt from the passive income rules of the Subpart F provisions, and the passive foreign investment company rules exempt active banking operations from the operation of those rules.

³ These recommendations are consistent with the comments included in the letter addressed to Treasury Secretary Jacob Lew by Ranking Member Sander Levin and other Members of the Committee on Ways and Means, dated June 22, 2016. In the letter, the Members note the challenges presented by the Proposed Regulations to the financial services business sector, among other businesses, as a result of regulatory requirements unique to this business sector. The letter also recognizes that as drafted, the Proposed Regulations may adversely impact ordinary course business transactions among affiliates which are undertaken with no tax-avoidance purpose. Similarly, the letter addressed to Treasury Secretary Jacob Lew by Chairman Kevin Brady and other Members of the Committee on Ways and Means, dated June 28, 2016, recognizes that provisions currently included within the Proposed Regulations would significantly impact capital structuring and ordinary course business transactions and operations.

⁴ Note that other jurisdictions have provided safe-harbor provisions to ensure that regulatory debt instruments are treated as debt for tax purposes. Examples of countries which have clarified or amended their law to ensure the deductibility of interest on regulatory debt instruments include the United Kingdom, Hong Kong, and Germany, among others. See for example, the UK Revenue & Customs Policy Paper regarding certain banking securities at: https://www.gov.uk/govemment/publications/revenue-and-customs-brief-24-2014-special-securities-provisions-of-the-corporation-tax-distributions-rules/revenue-and-customs-brief-24-2014-special-securities-provisions-of-the-corporation-tax-distributions-rules.

⁵ As a US bank holding company, HNAH is subject to regulation under the Bank Holding Company Act of 1956, as amended ("BHC Act"), and to inspection, examination and supervision by its primary regulator, the Federal Reserve Board ("FRB"). The HNAH Group is also subject to regulatory oversight of the Office of the Comptroller of the Currency ("OCC").

⁶ Further information regarding the HSBC Holdings plc group structure and businesses is available at http://www.hsbc.com/about-hsbc/structure-and-network.

⁷See Attachment 1 to the IIB Letter for a summary of the regulatory framework applicable to banking organizations.

⁸ In some cases, to achieve the magnitude of required related party debt under applicable regulatory frameworks, IHCs will be required to replace existing external debt and/or existing internal or external Tier 2 debt in order to create capacity to issue the required amount and form of mandated internal debt, such as Internal TLAC Debt.

⁹ RWAs are computed by assigning various risk weights prescribed by the Basel III framework to a banking group's assets and off-balance sheet exposures. Different classes of assets have different risk weights associated with them under the applicable capital framework.

¹⁰ The principles under which the FRB's TLAC proposals were issued require that G-SIBs conform to a minimum TLAC requirement at the level of each resolution entity. A resolution entity is an entity to which locally applicable resolution tools would be applied, in accordance with the overall resolution plan of the G-S1B. The HSBC Group, including HNAH, maintains a Multiple Point of Entry ("MPoE") resolution strategy which has been approved both by the PRA and FRB with respect to the HNAH Group. Under this plan, HNAH is a resolution entity, and any resolution of the HNAH Group would be expected to occur under supervision of the FRB by executing a "bail-in" plan to recapitalize the HNAH Group locally, without involving the remainder of the HSBC Group or requiring co-operation with other regulators. In contrast to the FSB guidance of allowing a resolution entity of an MPoE group to issue TLAC externally, the FRB's TLAC proposal requires HNAH, as an 1HC, to issue Internal TLAC to its parent.

¹¹ Certain significant challenges presented by the Proposed Regulations are described herein. Please refer to Section II of the IIB Letter for an illustration and more detailed discussion of how these challenges will adversely and unfairly impact the banking operations of regulated financial institutions, and IHCs in particular.

¹² These recommendations are intended to echo those in the IIB Letter. The HNAH Group fully supports the recommendations as well as the explanations and rationales for such recommendations reflected in the IIB Letter.