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Capital Markets Workshop Presented by KPMG LLP November 5, 2014
Mark H. Price, Principal, KPMG Ron Copher, CFO, Glacier Bancorp Justin Weiss, Managing Director, KPMG Jeremy M. Josse, Managing Director, KPMG David L. Konop, Senior Manager, KPMG
DISCLAIMER
The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.
You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
3
Agenda
Short-Term Expectations About Interest Rates Taxation of Debt Transactions
Derivatives and the Banking Industry
Taxation of Derivatives
4
Short-Term Expectations About
Interest Rates
Short-Term Expectations General expectations are for an increase in short-term rates at some point
during 2015. Should this come to pass, this is expected to be good for banks of all sizes.
• This expectation is based upon the idea that assets reprice more quickly than liabilities. • More specifically, most bank loans are contractually priced as a base rate (Prime, LIBOR,
Treasury) plus a spread. • Base rate increases => loan rate increases.
• On deposit side of balance sheet, while liabilities will reprice upwards, history shows: • Deposits do not reprice at the same magnitude as assets (i.e., a 25 bps increase in a
benchmark rate will result in only, say, a 15 bps increase in deposit rates). They are inelastic relative to short-term rate increases.
• Deposits do not reprice at the same pace as assets (i.e., there will be a time lag between an increase in benchmark rates and an increase in deposit rates). Deposit rates (with the exception of fixed maturity deposits) are generally not contractual.
• Increasing rates usually indicate that the economy is improving. If so, there may be increased demand for fee-based services, e.g. wealth management, treasury, etc.
However, there are other items on financial institutions’ balance sheets that could offset these positives and affect customer behavior in unexpected ways.
6
Rate Increase Effects Many institutions have pursued more aggressive investments and looser
credit underwriting standards in a pursuit of yield. • Some of these investments include:
• Asset backed securities (residential & commercial mortgages, auto loans, credit cards), sometimes of the subprime variety
• High yield bonds • Investments such as these may prove less sensitive to increases in
benchmark rates and, in fact, their value may decrease in the face of higher rates for safer assets.
7
Rate Increase Effects Institutions that have made loans with floors may require multiple rate
increases in order to realize increased interest income. • Ex. If the base rate is 1% below the floor, then a 0.25% base rate increase will have no effect on
interest income.
Libor floor levels have steadily declined since 2012 and have recently leveled off around 100 bps.
The percent of new-issue first-lien loans with a Libor floor has risen from a recent low of 90% in April 2013 to around 100% for the month ended September 4, 2014.
Source: Standards & Poor | Leveraged Commentary & Data
New-Issue First-Lien Libor Floor Percent and Level
0 bps
20 bps
40 bps
60 bps
80 bps
100 bps
120 bps
140 bps
160 bps
84.0%
86.0%
88.0%
90.0%
92.0%
94.0%
96.0%
98.0%
100.0%
102.0%
Percent Floor level 8
Rate Increase Effects Portfolio composition will play a key role
• Assets such as C&I loans and HELOCs tend to have floating rates. • Assets such as residential and some commercial mortgages may have fixed rates
that will not be sensitive to short-term rate increases. • Investments such as longer term bonds may not be sensitive to short-term rate
increases and if they are not held to maturity, banks may realize lower valuations with potential ill effects on capital positions and therefore lower NIM and greater equity retention requirements
Securitization
• Institutions that have been active in securitizing their long-term assets (e.g. packaging/selling residential mortgages) may find themselves in more flexible positions than those that hold.
Loan Allowances
• These have increased earnings for the industry over the last several years as reserves have been released. This trend is largely over and will at the very least stabilize, if not reverse, as rates increase.
9
Rate Increase Effects On the deposit side…
• Banks that have significant retail networks and strong deposit gathering franchises may find themselves in a much stronger position than…
• Banks that rely heavily upon short-terms market borrowings such as Fed borrowings and FHLB advances. Banks that rely on these will find their liabilities increasing in lock-step with their floating rate assets.
10
Liabilities Other Sources of Funding
• Generally speaking, larger institutions are more likely to tap the capital markets for long-term debt as a source of funding
• As we move closer to a rate increase, institutions that have traditionally declined to participate in the capital markets may consider long-term debt as a possibility.
11
Collateralized Loan Obligation Vehicle Update
Source: Standards & Poor | Leveraged Commentary & Data
Leveraged Loan CLO Activity – by Month
6.98
10.60
7.05
2.55
8.94
11.15 12.33 12.23
13.78 13.39
10.68
0.37
$0B
$5B
$10B
$15B
The loan market’s technical condition was steady in August as slowing supply growth and stronger-than-expected CLO issuance balanced rising retail outflows.
The CLO market remains robust, producing $10.68 billion new vehicles in August, versus $13.4 in July. That lifted CLO volume for the first eight months of 2014 to $85 billion, which tops 2013’s full-year figure of $82.6 billion and is just $12 billion shy of 2006’s all-time high of $97 billion.
Managers expect CLO issuance to roughly track new net supply as demand for AAA paper in an L+145-155 range exist. And with collateral cheaper, equity dollars remain plentiful. Therefore, despite less enthusiasm for lower-rated mezzanine debt, managers expect the CLO engine to continue along during the final leg of 2014.
The uncertainty is what happens with retail flows. Managers say that given the recent stabilization in interest rates – after falling steadily from a multiyear high of 3.04% at year-end, the 10-year Treasury yield has ranged from 2.34-2.46% between August 7 and September 5 – they expect outflows to remain contained.
12
Customer Behavior Borrowers
• Borrowers with long-term contractual rates (e.g., residential mortgages) are: • Less likely to refinance – this has already been happening as refinancing activity
has slowed down • Less likely to pre-pay – the effective duration of portfolios may increase • The value of retained servicing rights should increase as duration of underlying
portfolio values increase • Borrowers with short-term contractual rates:
• May be more likely to default (although small increments of rate increases mean this effect will likely be muted)…effect on TDRs and workouts
• May be quicker to pre-pay or slower to increase borrowings • Have borrowers swapped into fixed arrangements? If so, there may be little/no
behavior changes until maturity • Customer behavior can also create unexpected tax consequences. As we
will see, refinancings that appear routine could have tax implications such as being “significant modifications” and the refinanced debt having OID.
13
Customer Behavior Depositors
• Rate-sensitive customers may return to banks as places to park money (many have drifted to other institutions or instruments during this time)
• May become more demanding when it comes to deposit rates • Increase in “hot money” behavior may destabilize funding sources
14
Premium Bonds - Hedges Against Rising Rates Why do premium bonds protect against rising interest rates?
• They have higher stated interest, and thus higher and faster cash flow than par bonds. If interest rates rise, this increased cash flow can be reinvested at the new, higher rates.
• They are less sensitive to interest rate changes. Because premium bonds return cash flow faster, their prices change more slowly as interest rates change.
15
Premium Bonds - Hedges Against Rising Rates Example
• A bank pays $107 for a bond with a face of $100. The bank pays the $7 premium because the bond’s interest rate (5%) is above market (4%).
• Even though the bank will only receive $100 at maturity, it will also receive $5 a year while a par bond would return only $4 a year.
• If market rates rise to 6%, the bank will have received more interest payments than on a par bond, and it can now invest those interest payments at the now-higher market rate of 6%.
• Also, as we will see, the bank does not include the full $5 of annual interest payments in income for tax purposes.
16
Debt Transactions
Agenda
Bond Premium Acquisition Premium
Market Discount
Debt Modifications
18
Bond Premium
Bond Premium - Section 171
Definition – • Bond premium is the amount by which a holder’s basis exceeds the stated
redemption price at maturity. • In other words, a bond is trading at a price higher than the amount payable
at maturity. Bond Premium = Basis – SRPM
General Rule – • Bond premium is amortized over the remaining term of the debt on a
constant yield basis as an offset to interest income. • Amortization is elective for taxable bonds. • For tax-exempt bonds, amortization is mandatory: Holders must reduce
their basis by the amortized premium, but they receive no deduction. • This basis reduction creates a permanent difference.
20
Bond Premium - Section 171
If a bond with bond premium also has OID, the holder includes none of the OID into income. • This makes sense because OID is a form of yield. For example, if a holder
lends a borrower $97 but the borrower is obligated to repay $100, the extra $3 is additional yield. However, when a secondary purchaser buys a bond for more than its face (say, $105), no portion of that $100 is yield to the secondary holder; it is a return of capital.
21
Bond Premium - Section 171
Example: • A bank buys a bond on the secondary market for $107. • The bond has a face of $100 and unaccrued OID of $4. Its AIP is $96. • The bond has $7 of bond premium and the bank’s basis is $107. • After one year, $1 of OID and $3 of stated interest have accrued. Also,
$1.25 of the bond premium has accrued. • The bank does not include any of the accrued OID in income and only
includes $1.75 of the stated interest. • The bank’s basis in the bond decreases by $1.25 to $105.75.
22
Acquisition Premium
Acquisition Premium - Section 1272(a)(7)
Definition – • Acquisition premium occurs when a holder buys a bond on the secondary
market and its basis in the bond is greater than the bond’s adjusted issue price but less than its stated redemption price at maturity.
• I.e., if AIP < basis < SRPM, then acquisition premium exists.
Acquisition Premium = Basis – AIP
Example: • A bank buys a bond on the secondary market for $98. • The bond has a face of $100 and unaccrued OID of $7, so its AIP is $93. • The bond has $5 of acquisition premium.
24
Acquisition Premium - Section 1272(a)(7)
General Amortization Rule – • Acquisition premium is amortized over the remaining term of the debt as an
offset to OID. • Fraction method: the holder reduces OID inclusions by this fraction –
Acquisition Premium Remaining OID
• Election to amortize under a constant yield.
25
Acquisition Premium - Section 1272(a)(7)
Example: • A bank buys a bond on the secondary market for $95. • The bond has a face of $100 and unaccrued OID of $13, so its AIP is $87. • The bond has $8 of acquisition premium. • The fraction is 8/13. Thus, 8/13 of each OID accrual is not included in income. • After one year, $2 of the OID has accrued. The amount of OID that the bank
must include in income is $2 x (5/13), or about $0.77.
26
Market Discount
Market Discount - Sections 1276 - 1278
Definition – • Market discount occurs when a holder buys a bond on the secondary market
and its basis in the bond is less than the bond’s stated redemption price at maturity (if no OID) or adjusted issue price (if OID).
Market Discount = SRPM (or AIP) – Basis
• Example #1:
• A bank buys a bond on the secondary market for $87. • The bond has a face of $100 and no OID, so it has $13 of market discount.
• Example #2:
• A bank buys a bond on the secondary market for $93. • The bond has a face of $110 and unaccrued OID of $6. Thus, its AIP is $104. • The bond has $11 of market discount.
28
Market Discount, Cont’d
General Recognition Rule – • Accrued market discount is treated as ordinary income upon –
• Receipt of partial principal payments, or • Disposition (to the extent of gain).
• Election to include currently.
• Portion that is ordinary income is treated as interest for most purposes.
• Tax-exempt bonds can have market discount; if they do, the market discount is not tax exempt.
29
Market Discount, Cont’d
Accrual of Market Discount – • Single Principal Payment –
• Ratable accrual unless elect constant yield. Ratable accrual is: (Total market discount) x (# of days held)
Total # of days from purchase date to maturity • Ratable is easier to apply but accrues quicker.
• Multiple Principal Payments – • Constant yield method, or • An approximate method (a.k.a. the interest-over-interest method and the
OID-over-OID method).
30
Market Discount, Cont’d
Example: • A bank buys a bond on the secondary market for $93. • The bond has a face of $100 and unaccrued OID of $3, so its AIP is $97.
Therefore, the bond has $4 of market discount. • The bank has not received principal payments and has not elected to
accrue market discount currently. • Two years later, $1 of OID has accrued and $2 of market discount has
accrued. The bank’s basis in the bond is now $94 ($93 + $1 of OID). • The bank sells the bond for $99 and realizes $5 of gain. • Of this amount, $2 is treated as ordinary income on account of the accrued
market discount. The remaining $3 is either capital or ordinary, depending on the circumstances (likely ordinary under section 582(c)).
31
Market Discount, Cont’d
Interest Deferral Rules – • Section 1277 prevents interest (that exceeds interest income from the
bond) to be deducted on indebtedness incurred or continued to purchase or carry market discount bonds.
• Prevents taxpayers from taking deductions currently and including market discount in income later.
• The disallowed portion is deductible when the bond is disposed of.
32
Debt Modifications
Debt Modifications - Section 1001
A “significant modification” of a debt is treated as a taxable exchange of the pre-modification (“old”) debt for the modified (“new”) debt.
History – • Cottage Savings: “hair trigger” test. • Section 1.1001-3 treats only “significant modifications” as taxable events.
Two Part Test • Was there a “modification?” • If so, was the modification “significant?”
34
Part 1 – Was there a “modification?”
Modifications – • A change of a legal right or obligation of the issuer or the holder.
• A change in obligor.
• A change in nature of instrument (e.g., from debt to non-debt).
• A change in recourse nature.
A modification can be effected by direct agreement between the parties
or by the conduct of the parties.
35
Part 1 – Was there a “modification?”
Not a modification – • A change pursuant to the terms of the instrument (e.g., a variable rate of
interest based on 3-month LIBOR).
• A change resulting from the exercise of a unilateral option. • If a party to a debt instrument has an option to change a term of the
instrument, the failure of the party to exercise that option is not a modification.
• A failure of the issuer to perform.
• An agreement by the holder to stay collection or waive acceleration, but only
if the holder’s forbearance lasts no more than two years.
36
Part 2 – Was the modification “significant”?
When is a modification “significant” – • When the legal rights or obligations are altered in an economically significant
manner.
• The regulations provide specific rules for five types of modifications.
• Multiple modifications – • Modifications done over time may be evaluated together to see if they
would be significant had they been done collectively, at the same time. • Modifications tested under the five specific rules are not considered
collectively.
37
Part 2 – The Five Specific Significance Rules
Change in yield • More than greater of 0.25% or 5% of unmodified yield.
Change (deferral) in timing of payments
• More than lesser of 5 years or 50% of original term. • Difficult to apply with amortizing loans
Change in obligor or security Change in the nature of the debt
• Any deterioration in issuer’s financial condition is generally not considered.
Change in accounting or financial covenants
38
Consequences of a Debt-for-Debt Exchange
Issuer – • Potential COD income if the adjusted issue price of the old debt is greater
than the issue price of the new debt.
• Possible OID deductions going forward.
• Bond repurchase premium if issue price of new debt is greater than adjusted issue price of old debt. Bond repurchase premium may need to be spread over term of new debt.
• Need to retest for AHYDO and other interest disallowance provisions.
39
Consequences of a Debt-for-Debt Exchange
Holder – • Amount realized generally equals the issue price of the new debt.
• Gain or loss not recognized in a recapitalization.
• Is the debt a “security?”
• Holder may have OID income going forward.
• Does Section 453 (installment sale) apply?
40
Example of Debt Modification
Facts Borrower enters into a fixed-rate debt at 3% (market rate at the time).
A few years later, Borrower is struggling to make payments on the
debt, so it negotiates with Bank to extend the maturity date in exchange for an increase in the interest rate to 4%.
Assume that, from the time Borrower entered into the debt to the time of the refinancing, market rates (and relevant AFR) have risen to 5%.
41
Example of Debt Modification, cont’d
Analysis The 1% increase in the debt’s rate is a significant modification
because it increased the debt’s yield substantially. For tax purposes, the pre-refi debt is deemed exchanged for the post-refi debt.
Because market rates (and AFR) have risen so sharply, the deemed new debt does not provide for “adequate stated interest” under Section 1274. The consequence of this is that the new debt’s issue price will be its “imputed principal amount,” which will be lower than its face amount, creating OID on the new debt and a loss on the old.
Therefore, in what appears to be a routine refinancing, because the external interest rate environment has changed so dramatically, the refinancing can have unanticipated tax results.
42
Example of Debt Modification, cont’d
Suggestions Put a floor on the interest rate of the newly refinanced debt. The floor
could be the relevant AFR, thereby guaranteeing that the new debt would provide for adequate stated interest and avoiding OID.
Create a process for identifying refinancings that might have tax implications and having the tax department review the transaction.
43
Derivatives and the Banking Industry
Overview Presentation focuses on the broader landscape of the use and role of
derivatives by US banks, in particular:
Impact of Dodd-Frank and the Volcker Rule on use of derivatives
Overview of current function of derivatives as on balance sheet hedging products and as client product offerings
Use of derivatives by National and Community Banks
45
Impact of Dodd-Frank and the Volcker Rule
Background Dodd-Frank Act Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-
Frank Act) enacted in 2010
Tasks the SEC and CFTC with implementing the sweeping changes to the derivative markets provided for under Title VII of the Dodd-Frank Act
Promulgation and implementation of the vast rules contemplated under Title VII is currently ongoing
However, many rules are currently in force and all indications are that rules will continue to be rolled out on an ongoing basis
Background
47
Impact on Derivatives Title VII of the Dodd-Frank Act
Changes to the OTC Derivatives Markets Under Title VII Include: Mandatory central clearing for many “swaps” (defined in Dodd-Frank Act)
Requirement for trading in many “swap” transactions on exchanges or so-called
“swap execution facilities” “Swap Execution Facilities” – nature of these trade execution facilities remains unclear
New collateral and margining requirements
Trade reporting and record-keeping requirements
Position limitations
End-User Exception – may exempt certain users of derivative products from some
of these new rules and requirements Detailed rules define scope of this exception
48
Comparing Derivatives Markets Pre & Post Dodd-Frank Act
Many Derivatives Executed on an OTC Basis
Clearing Generally at Discretion of Parties
OTC Execution Carried Greater Likelihood of “Bespoke” Terms
More Likely Derivatives Executed on Exchanges
(or “SEFs”)
Mandatory Clearing for Many Derivatives
Greater Emphasis on “Standardized” Terms
Proliferation of New Swap & “Swap-Like” Derivative
Products
PLUS
Pre- Post-
49
Overview Volcker Rule
Volcker Rule – Section 619 of Dodd-Frank Act Rule prohibits banking entities from engaging in propriety trading of financial instruments, including derivatives, for their own account Generally, the majority of trading at community and small national banks is in securities exempted from the Rule such as US Treasuries, GSE Agencies, Municipals, and FDIC obligations
- Underwriting - Market-making - Risk-mitigating hedging - Trading in domestic government
debt - Trading on behalf of customers - Trading by insurance companies
Permitted Proprietary Trading
- Purchasing or selling repos - Securities lending - Liquidity management - Clearing - Delivery and judicial obligations - Agent, broker, or custodian
transactions - Employee benefit plan
Transactions - Debt collections
Not Proprietary Trading - Conflict of interests (can be mitigated with proper client disclosure and information barriers)
- Material exposure to risky assets or strategy
- Threaten safety & soundness of institution and the financial stability of the US
Overriding Limitations
Source: Baker & McKenzie; Sullivan & Cromwell LLP 50
Overview Volcker Rule
Rule also prohibits banking entities from owning, sponsoring, or having certain relationships with hedge funds or private equity funds (“covered funds”)
Broad definition of “ownership” includes any derivative of an ownership interest
Banks required to report trading metrics to regulators based on worldwide consolidated trading assets/liabilities:
- Wholly owned subsidiaries - Joint venture and acquisition vehicles - Foreign pension or retirement funds - Insurance company separate accounts (including BOLI) - Public welfare investment funds - Any entity formed by, or on behalf of, the FDIC for the purpose of
facilitating the disposal of assets acquired in the FDIC’s corporate, conservatorship, or receivership capacity
- Issuer of securities with all collateral comprised of loans
Not Considered “Covered Funds”
2014 2015 2016
June 30: Banks over $50B
April 30: Banks over $25B
December 31: Banks over $10B
July 30: General
conformance period ends
Source: Baker & McKenzie; Sullivan & Cromwell LLP 51
Requirements on Banks that Engage in Proprietary Trading Volcker Rule
Simplified Requirements: Banks under $10 billion in consolidated assets No formal action required Must include references to the Volcker Rule requirements in existing policies and procedures
Standard Requirements: Banks over $10 billion but less than $50 billion in consolidated assets
Written policies and procedures designed (1) to ensure compliance with the requirements of the final rule and (2) establish trading and exposure limits for the activities conducted by the banking entity A system of internal controls to monitor and identify potential areas of noncompliance and to prevent prohibited activities A management framework that delineates responsibility and accountability for compliance Independent testing for the effectiveness of the compliance program Training for appropriate personnel Recordkeeping sufficient to demonstrate compliance
Enhanced Requirements: Bank over $50 billion in assets Required to reported quantitative metrics based on specific criteria CEOs of banks with significant trading activities must attest in writing to the compliance program’s ability to meet regulatory guidelines Source: Oliver Wyman 52
Use of Derivatives in Practice: Post
Dodd-Frank/Volcker
Derivatives Trading in Practice Derivatives trading is dominated by large money center banks, with JPM,
BAC, C, and GS controlling 92% of the market as of 1Q’14 Most common derivative instrument offered to clients is Interest Rate Swap
National and community banks primarily use derivatives for hedging purpose and offer very limited products to clients
These banks have minimal or no involvement in trading of credit and equity derivatives Community banks use low-risk, plain vanilla interest rate swaps either to hedge their own risks or serve the needs of their customers related to loans
Sources: Office of the Comptroller of the Currency 54
Community and National Banks Derivatives Trading in Practice
Historically, the derivative market has been dominated by the country’s largest four banks
Barriers to entry for community and national banks include upfront costs and sufficient personnel and infrastructure to manage dynamic regulations
92%
8%
$ Top Four Banks $ All Other Banks $-
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
Futures andForwards
Swaps Options Credit Derivatives
Share of Derivative Market (notional amount) – Q1 2014 ($ in billions)
Source: OCC
Share of Total
Derivative Market
Share by Derivative
Type
55
Volcker Rule Regulatory Challenges Facing Institutions
Approaches to adapting to new rules vary based on an institution’s size and scope of operations
Source: Oliver Wyman
Approach to New Rules Common Players Common Elements of Response to Date New Challenges
Proactive Major US Banks - Impact assessment - Tactical restructuring - Refined trading unit hierarchy - Initial compliance program implementation - Best efforts metrics design and development
- Shift to trading desk view of Volcker metrics - Managing liquidity management exemption - Managing hedging exemption - Setting meaningful limit structure
Balanced Major Foreign Banking Operations
- Impact assessment - Tactical restructuring - Refined trading hierarchy (case by case) - Compliance program implementation planning - Limited metrics design and development
- Assessing scope of foreign trading exemption
- Shift to trading desk view of Volcker metrics - Managing liquidity management exemption - Managing hedging exemption - Setting meaningful limit structure
Wait & See Smaller US and Foreign Players
- Impact assessments - Assessing scope of application under tiered regime
- Strategic decisions given cost of compliance - All of the above, depending on strategic
decisions
56
Strategies under Dodd-Frank and Volcker In order to comply with the Volcker rule and avoid regulatory uncertainty,
many national banks sold CLO and CDO instruments in early 2014 Grandfathering of TruPS CDOs – will similar treatment be granted to other structured products?
Shift in focus on structured products that are “bank eligible” – post-crisis, new issuances of CLOs that are “Volcker-friendly”
According to the Appleby Global Group Services, the market for CLOs is strong with 119 CLOs valued at more than $63 billion issued in the first half of 2014, up from 99 transactions with a total value of $48 billion in the first half of 2013
Seek “covered fund” exposure by investing in SBICs, which are exempt from Volcker Rule
57
Key Considerations Clearinghouses
Clearinghouses vary in products, margin requirements, collateral eligibility, and fee structure
Products Clearinghouses will vary in the type of derivative products they will clear Differences in both product type and currency
Margin requirements Financial institutions are required to post Initial Margin (IM) and Variation Margin (VM) for interest rate swap positions IM is calculated based on a clearinghouse’s proprietary VaR model; VM is calculated based on the mark-to-market performance of the swap
Collateral eligibility Clearinghouses have different sets of collateral (aside from cash) that qualify
Fee Structure Clearinghouses typically have two different fee structures available: Standard Fee Schedule (SFS) and High Turnover Fee Structure (HTS) Source: Morgan Stanley
58
Basics of Central Clearing
Derivatives Clearing Organization
(Clearinghouse)
Party X Party Y
Swap Terms Agreed on OTC Basis
Trade submitted by parties to DCO for
clearing
1
2
3
Cleared Swap Trade
3
Cleared Swap Trade
59
Derivatives: Money Center v. National v. Community Banks
Common Derivative Trading by Bank Size
Money-Center Banks National Banks Community Banks
Market-making
Hedging
Types of Contracts Offered to Clients
Interest rate contracts
Swaps
Futures and forwards
Written options
Purchased options
Foreign exchange contracts
Swaps
Spot, Futures and forwards
Written options
Purchased options
Equity contracts
Swaps
Futures and forwards
Written options
Purchased options
Sources: Company filings 61
Common Derivative Trading by Bank Size
Money-Center Banks National Banks Community Banks
Types of Contracts Offered to Clients (Cont’d)
Commodity contracts
Swaps
Futures and forwards
Written options
Purchased options
Credit derivatives
Purchased credit derivatives:
Credit default swaps
Total return swaps/other
Written credit derivatives:
Credit default swaps
Total return swaps/other
Sources: Company filings 62
Money-Center Banks Client Offerings under Dodd-Frank and Volcker Rule
Like community and national banks, money-center banks use interest rate derivatives as an ALM tool, but do much more also, including most of the market making in these products
In addition to vanilla interest rate derivative products, money center banks offer foreign exchange, equity, commodity, and credit derivatives
Institutions heavily involved in derivative trading and are typically members of global derivative exchanges Often have dedicated structured finance subsidiaries
Foreign exchange derivatives – spot, forwards, options, non-deliverable forwards and cross-currency swaps
Equity derivatives – convertibles, synthetics, flow derivatives, corporates, and structured products
Commodity derivatives – futures and forwards
Credit derivatives – credit default swaps, collateralized debt obligations, total return swaps 63
National and Community Banks Client Offerings under Dodd-Frank and Volcker Rule
Many national banks offer vanilla interest rate derivative products such as caps, floors, collars/ corridors, and cancellable swaps
Caps – protection in rising rate environment Floors – protection in falling rate environment Collars/ corridors – customer finances the purchase of a interest rate cap by selling an interest rate floor – “zero-cost” structure Cancellable swaps – one counterparty of the swap has the right to terminate the swap on one or more predetermined dates
Although less common than vanilla interest rate products, other derivative products at larger national banks include:
Cross currency swaps – gives each counterparty access to a different currency Swaptions – an option to enter into an interest rate swap Treasury locks – grants ability to lock in the current rate of federal gov’t securities
FX and interest rate swaps are the most common derivative offerings for community bank loan customers, with most banks offering little further in terms of a product set
Company Filings 64
Community and National Banks Derivatives Trading in Practice
National and community bank FX and interest rate swaps are usually of two types:
Two methods: One-way swap and back-to-back swap One-way swap is more popular with community banks – simpler transaction with fewer regulatory requirements Back-to-back swap is more popular with national banks – more required documentation which doesn’t scare away a national bank’s more sophisticated clients
One-way Swap: Loan customer receives fixed-rate loan and is not involved in a swap Bank manages its interest rate risk by making fixed rate loan and a floating rate swap
Source: FTN Financial
Fixed Rate Loan
Loan Customer 5.00%
Fixed Rate Loan
Bank 5.00%
Interest Rate Swap
Dealer
Floating Rate
One-way Example
65
Community and National Banks Derivatives Trading in Practice
Back-to-back Swap: Loan customer receives floating-rate loan and a swap Bank makes floating rate loan and two swaps Combination of a floating rate loan and a swap creates a net fixed rate for the borrower Two swaps on bank’s books offset creating a floating rate for the bank Bank receives up-front noninterest income from spread
Source: FTN Financial
Floating Rate Loan
Loan Customer Floating Rate
Floating Rate Loan
Bank
Interest Rate Swap (Dealer)
Dealer
Back-to-Back Example
Interest Rate Swap (Loan Customer)
Interest Rate Swap (Loan Customer)
5.00%
Floating Rate
Floating Rate
5.00% (4.75% base)
Non-interest Income $$ (25 bps spread)
Interest Rate Swap (Dealer)
66
Key Considerations Back-to-Back Swaps
Source: Derivative Path
- Unlawful for individuals who are
not Eligible Contract Participants to enter into a swap
- Required documentation must be signed before entering a swap with a bank customer
- Bank is responsible for recording customer trades to a Swap Data Repository within 48 hours of transacting
Compliance
- Must ensure that clients fully understand the mechanics of interest rate derivatives and the risks associated with the product
- Provide clients with scenario analysis modeling potential losses over the life of the swap
Marketing
- Risk that counterparty defaults when it had a net remaining obligations to the bank on remaining payments
- Bank must calculate credit exposure and obtain approval from regulators when underwriting the loan
Credit Exposure
- Simultaneous execution of two
trades - Both dealer and bank customer
enter into oral contract with the bank which is documented with trade confirmation immediately following the oral agreement
Trade Execution
- Servicing throughout the life of the trade including reporting to a Swap Data Repository and sending monthly payment notices and providing mark-to-market statements to bank customer
Trade Servicing
- Offering derivatives to customers (even in back-to-back situations) can cause certain tax considerations to arise (discussed below)
Tax
67
Community Banks Client Offerings under Dodd-Frank and Volcker Rule
Matched funding is a popular alternative to managing interest rate risk with swaps
Favored by community banks for the product’s simplicity Easier to explain to regulators and board members Simple accounting treatment – not measured at fair value like swaps and other derivatives
Loan Customer
5.00% Fixed Rate
Bank
3.00% Fixed Rate
FHLB Loan $$
Matched Funding Example
Loan $$
Fixed rate received from customer Fixed rate on FHLB Advance Bank’s return
5.00% 3.00% 2.00%
Source: FHLBBank San Francisco 68
Impact on Community and National Banks Volcker Rule Impact on Derivatives
Typically not involved in activities of money centers such as market making, underwriting, or proprietary trading
Commonly use interest rate swaps as a form of risk mitigation Under the Volcker Rule, banks will be required to quantify the risks they hedge against and record and measure the effectiveness of each hedge Every hedge must be in line with policies and procedures
Although rarely involved in underwriting, national banks often carry exposure to collateralized debt obligations (“CDOs”), collateralized mortgage obligations (“CMOs”), and collateralized loan obligations (“CLOs”)
These investments are often in the debt tranches of “covered funds” Shift in focus to securitizations that are 100% collateralized by loans – RMBS, CMBS, asset-backed commercial paper and credit card and auto securitizations
- Subject to internal compliance - Hedge or mitigate a specific risk - Cannot create a significant exposure that is not hedged - Subject to continuing review, monitoring and management; - Not reward proprietary risk taking; and - Document the transaction at the time of execution
Requirements for Risk Mitigation Hedging (i.e. interest rate swaps)
69
Taxation of Derivatives
Taxation of Derivatives – Introduction and Overview
71
Refresher on the Taxation of Derivatives • Forward Contracts • Options • Swaps • Futures Contracts • Straddles
Tax Implications of Dodd Frank Hedging Transactions Mark to Market – Section 475 Proposed Legislation Affecting the Taxation of Derivatives
Agenda
72
What drives the tax complexity?
VS. Other:
- Accounting for Upfront Payments
Timing Rules
Hedge Timing Rules
Straddle Rules
Mark to Market
Open Transaction
Character Rules
Tax Hedging Treatment
Termination Payments
§1256 (60/40)
Written Options §988
Status of Taxpayer
§475 Dealers & §475 Elections
Commodities Derivatives
Dealer
Member of Consolidated
Group
General Character Rules (§1221)
Affirmative Use of Identifications
NPC Timing Rules
§475
Hedgers, Traders or Investors
Hedging & Subpart F
Other
Hedging & §199 Deduction
State Apportionment Rules
Special Derivative Withholding
Rules
Unique Sourcing Rules
“Significant” Nonperiodic
Payments
73
Different tax regimes for economically similar derivatives
1256 Contracts
Character: Generally Capital (60/40 treatment)
Timing: Mark-to-Market
Other:
Hedge Timing Rules vs. MTM
Mixed Straddle considerations
VS.
Swaps (Taxed as NPCs)
Character: Generally Ordinary
Timing: Generally Realization Based Method
Other:
Accounting for Upfront Payments
74
Said another way… (for illustrative purposes only; not all combinations or instruments are depicted):
Foreign Currency Position
Regulated Futures Contract or exchange-traded option
OTC option
Other (non-spot) forward contract
Part of a properly and timely identified hedging
transaction
Not part of a hedging transaction
Part of a hedging transaction but not properly or timely identified as such
Mark-to-market under §1256; 60% long-term, 40% short-term capital gain/loss
May be subject to mark-to-market under §1256 (but uncertainty given potential application of hedge timing and straddle rules); ordinary (§988 or §1.988-1(a)(7))
Timing will match gain/loss realization on hedged item; ordinary under §988 and tax
hedging regime
Spot forward
§988(a)(1)(B) Election Made
§1.988-1(a)(7) Election Made
Mark-to-market under §1256; ordinary (§988 or §1.988-1(a)(7))
“Realization” based timing; ordinary under §988
Cash Settlement
Physical Settlement
No §1.988-1(a)(7) Election Made
May be subject to mark-to-market under §1256 (but uncertainty given potential application of hedge timing
and straddle rules); potential for character whipsaw (ordinary gains, capital losses)
No §988(a)(1)(B) Election Made (or
Available)
“Minor” currency
“Major” currency
“Realization” based timing; capital under §988(a)(1)(B)
“Realization” based timing (but uncertainty given potential application of hedge timing and straddle
rules); ordinary under §988
“Realization” based timing (but uncertainty given potential application of hedge timing and straddle
rules); potential for character whipsaw (ordinary gains, capital losses)
75
How we might approach the issue
What is the classification of the derivative contract for tax purposes? What are the generally applicable character and timing rules
applicable to the derivative contract (i.e., the “base case”)? Who is the taxpayer and how does the derivative contract relate to its
business? Has the taxpayer made any elections or taken affirmative steps to
alter the taxation of its derivative contracts from the “base case”?
76
What is the classification of the derivative contract for tax purposes? Tax rules for derivative contracts dictated largely by the unique
features of the derivative contract • Have to determine what the contract is for tax purposes:
• Forwards • Futures • Swaps/Notional Principal Contracts • Options • Other?
• Some derivatives are defined under the tax rules (e.g., “futures”) while others are not (e.g., “forwards”)
• Even if economics are similar, the characterization for tax purposes as one or the other can markedly affect the taxation
77
What is the classification of the derivative contract for tax purposes? (continued) Key Considerations
• Where was the contract acquired? • Exchange traded/cleared contracts vs. “over-the-counter” transactions • Who is the counterparty • Evolution in the derivative markets and Dodd Frank Act
• What does the contract provide for? • Optionality vs. “executory” contract • Physical settlement • Cash settlement • Payments by both parties and netting • Upfront premium payments or similar amounts
78
General tax rules applicable to derivatives – the “base case” Timing – what is proper method of accounting for derivative?
• “Open transaction” or “realization” based taxation • Forwards • Certain Options
• NPC timing rules (section 1.446-3) • “Mark-to-Market” regime (section 1256)
• Futures • Straddle Rules (section 1092)
79
General tax rules applicable to derivatives – the “base case” (continued) Character – Capital v. Ordinary
• May be determined by type of contract or underlying asset. For example: • Certain payments on Swaps/Notional Principal Contracts are ordinary in nature
by (proposed) regulation • Section 988 – certain FX contracts give rise to ordinary income/loss • Section 1256 – certain contracts subject to special character rule (60% long term
capital/40% short term capital)
Other • Section 1234A and termination or similar transactions • Section 1234(b) and written options
80
General tax rules applicable to derivatives – the “base case” (continued) Key Takeaways – Absent Taxpayer Elections or Affirmative Steps:
• Some derivatives may be subject to mark-to-market regime while others not
• Character may depend on the nature of the contract and the nature of the payment with respect to the contract
• Hedging transactions – generally applicable tax rules may create mismatches as to both character and timing between the hedge and the hedged item if no hedging identification is made and there are various “whipsaw” rules that can exaggerate the consequences of failing to properly identify hedging transactions
81
Taxpayer characteristics and affirmative steps
Taxpayer’s status and how the derivative relates to its business may affect the taxation of the contract • Hedging Identifications • Section 475
• Is taxpayer a “dealer” in securities? • Has taxpayer made one of the section 475 elections (for traders in securities or
dealers or traders in commodities)? • Commodities derivatives dealer status (section 1221(a)(6))
82
Taxpayer characteristics and affirmative steps (continued) Consolidated Groups
• Unique issues may arise where taxpayer is member of a consolidated group and the derivative contract relates in whole or in part to the operations and risks of another member of the group or an affiliated entity not within the consolidated group for tax purposes (e.g., CFC affiliate) • Separate entity election under hedging regulations • Implementing a “back-to-back” structure with central “hedging center” entity • Consider related issues such as transfer pricing
83
Taxpayer characteristics and affirmative steps (continued) Does the taxpayer claim the section 199 deduction?
• Identification requirements for hedging transactions and calculation of section 199 deduction
Is the taxpayer a CFC subject to the rules of subpart F? • Identification requirements for a CFC’s hedges of its own risks
Foreign counterparty and withholding implications? What special state apportionment rules might be applicable to the
derivative contract? • EX: are gross receipts or net gains (or neither) from a hedging transaction
included in a taxpayer’s sales factor?
84
Taxation of Derivatives – Futures Contracts
85
Futures Contracts - Overview
Standardized “forward-like” contracts traded on an exchange May be subject to special timing and character rules under section
1256
86
Futures Contracts - Compared to Forward Contracts
Forwards • Over-the-counter, private contracts; customized • Not marked to market under section1256 (other than certain foreign
exchange contracts, see below) Futures
• Standardized, traded on exchange; subject to margin and clearing rules • Generally cash settled • Marked-to-market under section 1256 • No counterparty credit risk
87
Futures Contracts – Tax Definition
“Regulated futures contract” is defined in section 1256: • Contract that is subject to a system of marking-to-market • Contract trades on, or regulated by, a “qualified board or exchange”
88
Other Section 1256 Contracts
Certain Foreign Currency Contracts • Requires delivery of, or the settlement of which depends on the value of, a
foreign currency which is a currency in which positions are also traded through regulated futures contracts,
• Which is traded in the interbank market, and • Which is entered into at arm's length at a price determined by reference to
the price in the interbank market. Nonequity Options
• Dealer Equity Options • Dealer Securities Futures Contracts
89
Taxation of Section 1256 Contracts
Mark-to-market regime for gain/loss Mark-to-market section 1256 contracts at
• Year-end • Termination • Assignment • Physical delivery (compare to forward contract)
The amount of gain or loss is adjusted to reflect any gain or loss previously taken into account
60/40 rule Several important exceptions
• Foreign Currency Contracts
90
Tax Implications of Dodd Frank Act
Dodd-Frank Act will likely lead to more derivatives being traded on exchanges. • Broad definition of “swap” for regulatory purposes suggests many derivatives
may be cleared / traded on exchanges. • Potentially subject to section 1256 as a result?
New section 1256(b)(2)(B) provides that a section 1256 contract does not include: • Any interest rate swap, currency swap, basis swap, interest rate cap, interest
rate floor, commodity swap, equity swap, interest rate floor, equity index swap, credit default swap, or “similar agreement”
Uncertainty as to what this exception covers • “…or similar agreement” • If instrument is covered by the exception, no 60/40 capital gain or loss
treatment under section1256 even if such instrument is centrally cleared or traded through a clearinghouse or exchange.
91
New Exchange-Traded “Swap-Futures” Products
New swap-futures products suggest that efforts are also underway to “futurize” the swap markets
Examples include: • Exchange-traded and cleared futures contracts that settle into a cleared
interest rate swap • Exchange-traded and cleared futures contracts that are intended to replicate
the economics of an OTC interest rate swap but are entirely cash settled and function in a manner similar to traditional financial futures contracts
In general, these derivative products share the following key features: • Generally standardized terms • Traded on “designated contract markets” and subject to margining and a daily
“marking-to-market” in the same fashion as traditional exchange-traded futures contracts • Each day, the parties to these derivative contracts will post “daily variation margin” as
the value of the contract moves and it is “marked-to-market” • Centrally cleared as a matter of course
92
DFA and Qualified Boards or Exchanges Potential Changes What trading platforms qualify as a “qualified board or exchange” may be
subject to change due to Dodd Frank. • Whether contract is traded on or subject to the rules of a “qualified board or
exchange” is a key factor in determining whether subject to section 1256. Historically, Treasury has issued guidance as to whether a particular
exchange met the standard and qualified. • Foreign exchanges typically requested a ruling from the Service as to their
status under the tax rules. Dodd Frank authorizes the CFTC to impose a registration process on
exchanges. • Service has indicated that if such a registration process is adopted by the
CFTC, exchanges that previously received a written determination on their status as a “qualified board or exchange” would nevertheless need to obtain an Order of Registration from the CFTC in order to maintain this status.
• Treasury and the IRS have stated that they will continue to evaluate the CFTC’s rules to determine if any changes to the IRS guidance process are warranted.
93
Dodd-Frank Act (Other Tax-Relevant Provisions) Derivatives
• Banks must limit swap dealings to certain permitted activities • May have to transfer swap portfolios to nonbank affiliates (“Swap Pushout Rule”) • Temp. Reg. section 1.1001-4 issued regarding transfer or assignment of certain
derivative contracts • Mandatory clearing of swaps; reporting and record-keeping requirements
94
Taxation of Derivatives – Straddles
95
Introduction - §1092
Straddle: “Offsetting positions” in “actively traded personal property” • Offsetting positions
• A “substantial diminution of risk of loss” from holding one position in personal property by reason of TP holding one or more other positions w/r/t personal property
• Personal property • Property (including stock) of a type that is actively traded
• Position • Direct and derivative ownership
96
Loss Deferral
Loss realized from a position that is part of a straddle is deferred to the extent of unrecognized gain at year-end in ANY offsetting positions or successor positions. • Unbalanced straddle? • Identified straddle regime • Mixed Straddles
Holding period rules Expense capitalization rule
97
Straddle - Example
Facts • On September 1, 2012, A enters into a long forward contract to buy stock
for delivery in February 2013. A also enters into a short forward contract to sell stock for delivery in April 2013.
• By December 1, 2012, the price of the stock has increased. A closes out the April 2013 forward contract at a loss of $1000.
• On February 1, 2013, A closes out the remaining forward contract at a gain of $980.
What are the tax implications of this transaction to A under the straddle rules?
98
Hedging Transactions
99
Hedging – Topics
Overview Requirements for a tax hedge Identification requirements Integrated debt instruments ASC 815 (Formerly Known as SFAS 133)
100
Hedging – Overview
Reason for undertaking hedging transaction? Risk Management (reduction)
• Taxpayers use derivative transactions to manage risk inherent in the operation of their business
• Risk may arise from a specific asset • Risk may arise from overall business operations
Match character of hedged transactions • Normal trade or business operations typically generate ordinary income
and losses • In absence of hedging treatment, potential capital character of gain or
losses from hedging transaction
101
Hedging – Overview (continued)
Hedging Rules • A transaction must qualify as a hedging transaction under §1221 • A transaction must be properly identified as a hedging transaction
The hedging rules are mandatory • Non-compliance could result in a character whipsaw • Gains from the transaction could be ordinary and losses capital
Identification & Documentation is important • Hedging identifications should be revisited • ASC 815
102
Hedging – Requirements for Tax Hedge
Requirements for Hedging Transactions • Entered into in the normal course of a trade or business • “Primarily” to manage certain risks resulting
• From holding ordinary property, or • Incurring certain obligations
103
Hedging – Requirement 1 “Normal Course” of Trade or Business Broader concept than “ordinary course of trade or business” Generally a transaction in the “normal course” is one that furthers a
taxpayer’s trade or business • Includes business expansion, other capitalizable activity • Usually not hard to meet if the taxpayer is in a trade or business • May become an issue if the entity entering into the transaction is not an
operating company but instead an SPV with no trade or business
104
Hedging – Requirement 2 Intent “Primarily” to Manage Risk
• Examines taxpayer’s intent • Based on all facts and circumstances
• Corporate minutes or other records are good evidence of intent • Should thus document rationale for entering transaction
• Cannot be a transaction entered into for speculative purposes exclusive of trade or business
105
Hedging – Requirement 3 Types of Risk Types of Risk Transaction Can Manage
• Interest rate risk • Price risk or • Currency risk
Note: Revenue risk and credit risk are not mentioned
106
Hedging – Requirement 4 Manage Risk Transaction must manage Risk A transaction that is entered into to reduce risk is treated as managing
risk Can reduce aggregate risk or specific risk Transactions that may manage risk
• Written options • Fixed to floating price hedges • Interest rate conversions • Counteracting hedges (transactions designed to counteract an existing hedge) • Recycled hedges (using the same hedging transaction to hedge a different
asset or liability) Transactions that are not hedging transactions
• Purchase or sale of debt instrument, equity security or annuity contract
107
Hedging – Requirement 5 Ordinary Property or Obligations Hedging transactions hedge risk regarding
• Ordinary property and ordinary obligations • Property is ordinary property only if a sale or exchange of the property by the
taxpayer could not produce a capital gain or loss under any circumstances.
Debt instruments are generally capital assets unless a dealer holds them • Exception for banks under §582
Taxpayer does not need to currently hold hedged item • Example – TP expects to borrow in 6 months may enter transaction to
hedge against increases in interest rates over that period even though not a current liability
108
Hedging - Character Rules
Character Matching • A properly identified hedging transaction permits characterizing the
gain/loss from the hedge as ordinary Proper Identification
• May not qualify for character matching if TP fails to identify a hedge properly
109
Hedging - Identification Requirements
Taxpayer must clearly identify hedging transaction on day acquired, originated or entered into
Taxpayer must identify the “hedged item” (e.g., the asset, liability or aggregate risk) within 35 days of entering the hedge • Includes identifying transaction that creates risk and type of risk that
transaction creates Taxpayer maintains identifications on taxpayer’s books and records
(nothing sent to IRS) • Must state identification for §1221 (for tax purposes) – GAAP ID is
insufficient (i.e. that used for ASC 815) • Example: TP could designate particular trading account as including only
hedging transactions and document in tax records that all interest rate swaps in that account designed to manage borrowing costs
110
Hedging - Character Rules-TP Identifies Hedge
If TP properly identifies hedge, and the hedging transaction qualifies as hedge, then ordinary income/loss
If TP performs same-day identification but – • Other identification requirements are not met, gain is ordinary • The transaction does not meet the other criteria for a hedge, the character
of loss is determined without regard to whether the transaction mitigates business risk, etc.
111
Hedging - Character Rules - TP Identifies Hedge (continued) If TP identifies as a hedge a transaction that does not qualify as a
hedge, gain will be determined as if the identification had not been made so long as— • The identification was an “inadvertent error” • All [similar] transactions in open years are being treated “consistent with
the principles of this section” [i.e., not as hedges] Note -
• Scope of exception unclear • PLR suggests inadvertent = “accidental oversight or carelessness” (PLR
2000-52-010)
112
Hedging - Character Rules – TP Fails to Timely Identify Transaction That Qualifies as Hedge General Rule
• Binding - transaction not hedge • Gain and loss determined without regard to whether transaction was
surrogate for noncapital asset Inadvertent Error Exception
• TP’s failure to identify due to inadvertent error and TP treated transactions in all open years similarly
• Gain or loss from transaction may be treated as ordinary Anti-Abuse Rule
• Generally if no reasonable grounds for treating transaction as other than hedging transaction, gain is ordinary
113
Hedging - Identification Requirements – Specific Identification Rules Anticipatory asset hedges
• Must identify the expected dates and amounts of the acquisition Inventory hedges
• Must identify type or class of inventory that hedge concerns Debt hedges
• Existing debt hedges – must specify the issue of existing debt being hedged
• Debt to be issued – expected date of issuance, expected maturity, expected issue price, and expected interest provisions
114
Hedging - Identification Requirements - Specific Identification Rules (continued) Aggregate risk hedges
• Must describe risk being hedged • Must describe hedging program under which hedging transaction was
entered Counteracting hedges
• Must identify the original hedge and the original hedged item
115
Hedging - Timing Rules for Hedging Transactions
Generally • The timing rules that govern hedging transactions (§1.446-4) require
taxpayers to choose a method that clearly reflects income • To clearly reflect income, the method must reasonably match the timing of
income/loss from the hedging transaction with the hedged asset • Taking gains or losses into account when realized may not clearly reflect income
If a transaction meets the requirements for a hedge, hedge accounting applies whether or not the transaction is identified as a hedge (Rev. Rul. 2003-127)
116
Hedging - Timing Rules for Hedging Transactions (continued) Choice of Timing Rule
• TPs can choose any method that clearly reflects income (more than one method may be reasonable)
• Once taxpayer chooses method, it must apply that method consistently Record Keeping
• In tax books and records, TP must include a sufficient description of the accounting method used for each type of hedging transaction
• Description must show how clear reflection standard is met
117
Hedging - Specific Hedge Timing Rules that Generally Clearly Reflect Income Hedges of debt instruments
• Coordinate income/deduction from hedge (covers specified periods) with interest or OID on the debt • Example - Assume that a fixed-rate debt instrument is outstanding
• The taxpayer takes the income/deduction from the hedge into account in the same periods as income/deduction on debt as if adjusted the yield of debt over the term of the hedge
118
Hedging - Specific Hedge Timing Rules - Example
TP hedges fixed rate debt with swap that synthetically converts fixed rate into floating rate
Debt has 5 year term and swap has 5 year term TP then terminates the swap before the 5 year term Gain/loss from swap termination must be accounted for over the
remaining period of the debt to which the swap relates So if TP terminates swap on last day of year 2, must take gain/loss
from termination of swap into account over years 3 - 5 of debt
119
Hedges - Specific Hedge Timing Rules (continued)
Disposition of Hedged Item • TP disposes of hedged item but retains hedge • TP must match “built-in” gain or loss on hedge with gain or loss from
disposition of hedged item • Usually accomplish by marking the hedge to market when dispose of
hedged item • If intent to dispose of hedge within a reasonable period of time (7 days),
then match realized gain/loss from hedge with hedged item Recycled Hedge
• TP must match the built-in gain/loss from the hedge at the time of the recycling with the gain/loss on the original hedged item
120
Hedges - Relationship of Hedge Timing Rules to Other Timing Rules To the extent hedge timing rules conflict with other regulatory timing
rules, hedge timing rules control. Hedge timing rules do not apply in the following cases:
• A position subject to §475(a) • An integrated debt instrument • A §988(d) hedging transaction
Note • Hedge timing rules do not alter the character of the gains/losses from the
hedging transaction to match hedged item – they govern timing
121
Hedges - Integration of Debt Instrument and Hedge Under §1.1275-6 §1.1275-6 provides rules that permit the integration of certain debt
instruments with hedges of those instruments • The debt and the hedge are not taxed separately • Instead one set of rules generally applies to the “synthetic instrument” that
results from the integration • E.g., Integration of fixed rate debt instrument and hedge in the form of a
fixed to floating rate swap results in the tax accounting for floating rate debt • Primary benefit is relief from character, timing and source mismatches that
can arise when debt accounted for separately from hedge
122
Hedges - Integration of Debt Instrument and Hedge Under §1.1275-6 Contrast to Business Hedge Rules
• Rules apply to hedges of debt instruments • Debt does not have to be an ordinary asset or liability in the TP hands • Rules do not require TP to enter into the hedge in the normal course of its
trade or business • Rules lead to creation of synthetic debt instrument by integration
Election • The rules only apply to the TP making the election • Thus if issuer of debt enters into hedge and integrates them, issuer’s
integration treatment does not affect the holder Interest
• All interest is OID
123
Mark-to-Market – Section 475
124
Introduction to Section 475
What makes a taxpayer subject to section 475? • Merely originating loans?
How does being subject to section 475 affect timing and character? • Generally mark-to-market, ordinary for all securities (including loans)
• Exceptions? • Valuation? • Interaction with sections 1091, 1092, and 1256? • Special related party/consolidated return rules?
Which consequences are elective? • Elections at the entity/group level • Identifications at the security level
125
Section 475 Basics
Section 475 (a) generally requires dealers in securities to use the mark-to-market method of accounting for their securities
Dealer in Securities - A securities dealer is a taxpayer that either: • Regularly purchases securities from or sells securities to customers OR • Regularly offers to enter into, assume, offset, assign or otherwise terminate
positions Purchases?
• Purchase includes originating loans Customers?
• Related parties may be customers
126
Section 475 – What is a “Security”
What is a Security? • Corporate Stock • Publicly traded or widely held partnership interests • Notes or other evidence of indebtedness • Interest rate, currency, or equity notional principal contracts • Interest or derivative in any security above • Hedges of MTM securities
What is NOT a Security? • Taxpayer issued debt • REMIC residual interests • Non-financial customer paper • Section 1256 contracts
127
Section 475 – Negligible Sales Exception
Exception to Dealer Status – “Negligible Sales Exception” • Under this exception, a TP that regularly purchases securities (originates
loans) from customers in the ordinary course of its trade or business will not be considered to be a dealer in securities under section 475 if it: • Sells all or part of fewer than 60 debt instruments; or • The total adjusted basis of all of the debt instruments sold is less than 5 percent
of the total basis of debt instruments acquired during the taxable year • Do not count -
• Sales that exceptional circumstances compel and that are non-recurring • Sales of debt based on its decline in quality under TP policy • Purchases and sales of debt instruments that are qualitatively different from all debt
instruments that TP purchases from customers in the ordinary course
• What about agency sales and securitizations
128
Section 475 Identifications
Securities that TP may exempt from the mark-to-market rules • Securities Held for Investment (Regulations deem certain securities to be
held for investment) • Debt not held for sale to customers in the ordinary course of a trade or
business • Hedges of investment securities
Requirements for Exemption: • “Same day” identification • 30 day rule for loans originated by banks • Identification must be part of books and records • Must identify specific security (or specific accounts containing only such
securities) • Identification must cite section 475
129
Section 475 – IDs and Securitizations
(1995) Proposed Regulation Section 1.475(b)-3 • Exemption from MTM treatment for Contributed Securities
• If a taxpayer expects to contribute securities (for example, mortgages) to a trust or other entity, including a REMIC, in exchange for interests therein the contributed securities qualify as held for investment or not held for sale only if the taxpayer expects each of the interests received to be either held for investment or not held for sale to customers in the ordinary course of the taxpayer's trade or business.
• Exemption from MTM treatment for Resulting Interests • If a taxpayer contributes securities to a trust or other entity in exchange for interests
therein (including ownership interests or debt issued by the trust or other entity) and if, for federal income tax purposes, the ownership of the interests received is not treated as ownership of the securities contributed, the interests received may be identified as being described in section 475(b)(1), even if some or all of the contributed securities were not so described and could not have been so identified.
• For purposes of determining the timeliness of an identification of an interest received, the interest is treated as acquired on the day of its receipt.
130
Section 475 Protective Identifications
Protective Identification • If a taxpayer becomes a dealer (perhaps because the taxpayer no longer
qualifies for the negligible sales exception) then all securities held by such taxpayer will be subject to the mark-to-market method of accounting unless they are exempt • Even though the taxpayer was not a securities dealer at that time it bought/sold
the securities • It is not possible to subsequently identify securities and exclude them from
mark-to-market accounting after the close of the day on which they were bought/sold
• May thus be advisable for a taxpayer to make protective section 475(b) identifications of its securities [e.g., classify them as exempt] if there is a possibility that such taxpayer may some day be considered a dealer
131
Section 475 – Change in Status/Method of Accounting Change in Dealer Status
• “Once a dealer, always a dealer” (Revenue Ruling 97-39) • Requesting a change to a mark-to-market method of accounting (Revenue
Procedures 97-27 and 08-52) A taxpayer electing out of the negligible sales exception must file a
Form 3115 to obtain the automatic consent of the IRS to change its method of accounting for securities • No section 481(a) adjustment required • Consent for the method change is automatically granted if taxpayer
complies with Revenue Procedure 97-43 • Once a bank is subject to section 475(a), changing to a non-mark-to-
market method of accounting in the future requires the consent of the IRS. • Non-automatic, with section 481(a) adjustment
132
Section 475 – Ordinary Character Rules
Generally, any gain or loss with respect to a 475 security shall be treated as ordinary income or loss
Certain securities subject to section 475 are not subject to its character rule, including: • A security that a hedge with respect to either a security to which section
475 does not apply or a non-security; • A security not held in connection with activities as a dealer in securities;
and • Certain improperly identified securities (as defined in 475(d)(2)).
Note that the mark-to-market rules under section 475 may still apply even though the character rule does not
133
Section 475 Mark-to-Market Valuation
“Safe Harbor” Regulations (securities and commodities dealers) • In June 2007, Treasury and the IRS adopted “safe harbor” valuation
regulations that permitted securities and commodities dealers to use their financial statement valuations as the fair market value of those positions for purposes of section 475.
• Because the 2007 regulations contain significant limitations, many taxpayers have concluded that the application of the safe harbor is not practical.
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Section 475 Mark-to-Market Valuation (continued)
2011 Directive • The Directive applies to all taxpayers who are required to, or elect to, MTM
securities or commodities under section 475 and are required to file certain financial statements with the U.S. SEC.
• The Directive relaxes some of the restrictive requirements in the safe harbor regulations.
• Unlike the safe harbor regulations (which are limited to securities and commodities dealers), the Directive is applicable in principle to traders electing to apply the section 475 MTM regime.
• However, limited in its application, because many traders may not file qualified financial statements with the SEC – a requirement.
• Similarly, many commodities dealers may not file qualified financial statements with the SEC; rather, they report to the Commodities Futures Trading Commission.
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Section 475 – Interaction with sections 1091, 1092, and 1256 Section 1256 contracts are not section 475 securities
• What if a section 1256 contract is a section 475(c)(3) hedge of a section 475 security?
Section 1091 (wash sale rules) do not apply to securities subject to section 475
Section 1092 (straddle rules) do apply, but may have a minimal impact if the offsetting positions are subject to mark-to-market, ordinary under section 475
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Section 475 in lieu of Section 166
Some banks may want to use a mark-to-market method in lieu of section 166 • Election out of the negligible sales exception • Selectivity through identification
• e.g., acquisition of deeply discounted debt
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Section 475 – Related Party Considerations
Can a related party be a “customer”? • Outside the consolidated group – yes • Within the consolidated group – elective
What happens when section 475 securities are transferred between a dealer and non-dealer in the same consolidated group? • Section 475 is not a Reg. section 1.1502-13 “special status” • Transfer to dealer: deemed ID, then change in status • Transfer from dealer: no longer held in connection with dealer activity
(affecting character), but continue to mark-to-market
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Section 475 – Related Party Considerations
How does a consolidated group apply the negligible sales exception? • Intragroup-customer election not in effect
• The test can be satisfied either by treating the members of the group as if they were divisions of a single corporation, or by taking into account sales of debt instruments to other group members.
• Intragroup-customer election in effect • Sales to other group members are taken into account when applying the test.
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Section 475 – Elective Application for Certain Non-dealers in Securities Taxpayers that may elect into section 475
• Commodities dealers • Securities and commodities traders
• For activities to be considered a trade or business, trading must be substantial (i.e., sporadic trading not enough), TP Must seek to catch the swings in daily market movements, and to profit from the short-term changes, rather than profit from long-term investment
Benefits of making a section 475 election: • Conform book/economic/tax income
• Avoid wash sales rules • Ordinary gains and losses
• Elect separately for each trade or business “Principles” underlying the rules and interpretations for dealers apply
to traders
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Section 475 – Example Back-to-back Swap:
• Loan customer receives floating-rate loan and a swap • Bank makes floating rate loan and two swaps • Combination of a floating rate loan and a swap creates a net fixed rate for the borrower • Two swaps on bank’s books offset creating a floating rate for the bank • Bank receives up-front noninterest income from spread
Source: FTN Financial
Floating Rate Loan
Loan Customer Floating Rate
Floating Rate Loan
Bank
Interest Rate Swap (Dealer)
Dealer
Back-to-Back Example
Interest Rate Swap (Loan Customer)
Interest Rate Swap (Loan Customer)
5.00%
Floating Rate
Floating Rate
5.00% (4.75% base)
Non-interest Income $$ (25 bps spread)
Interest Rate Swap (Dealer)
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Camp tax reform discussion draft – Derivatives and hedging provisions New timing and character rules for derivatives:
• Require all derivatives (very broadly defined) to be marked to market for tax purposes • Relies on fair value determined in report or statement to owners or report or statement for credit
purposes • Exception for transactions that are part of a valid hedging transaction
• Treat all income, gain, loss, or deduction from derivatives as ordinary • Require other positions to be marked to market if part of a straddle with a derivative
• Built-in gain, but not loss, is included on entering into straddle • Replace several existing rules (e.g., section 1234A and section 1256)
Coordination of tax hedging rules with GAAP hedging regime: • Existing law requires hedging transactions to be identified for tax purposes as hedging transactions
on or before the day the transaction is entered. • Financial accounting identification does not meet this requirement
• New provision treats designation of derivative as hedging transaction for U.S. GAAP audited financial statements as a valid hedge identification for tax purposes.
• Transaction must still meet the substantive tax requirements to qualify as a tax hedging transaction. • Note that Camp Proposal also includes provisions that would alter the taxation of certain debt
instruments and other rules relating to cost basis reporting and wash sales.
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Obama administration FY 2015 budget proposals – Derivatives and hedging provisions Similar to Camp Proposal, would impose mark to market treatment for certain
derivatives • Proposal would require derivatives with respect to actively traded property to be
marked to market for tax purposes • More narrow in scope than Camp proposal given requirement that derivative
must be with respect to actively traded property • Treat all income, gain, loss, or deduction from derivatives marked to market under
proposal as ordinary • Similar to Camp, the mark to market proposal includes a carve out for derivatives
that are part of a hedging transaction
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Mark H. Price, KPMG mhprice@kpmg.com, 202.533.4364 Ron Copher, Glacier Bancorp rcopher@glacierbancorp.com Justin Weiss, KPMG justinweiss@kpmg.com, 949.885.5848 Jeremy M. Josse, KPMG jjosse@kpmg.com, 212.954.2814 David L. Konop, KPMG dkonop@kpmg.com, 313.230.3360
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