capital marketsworkshopslides(final)

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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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.

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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.

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Debt Transactions

Agenda

Bond Premium Acquisition Premium

Market Discount

Debt Modifications

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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).

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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)).

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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.

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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?”

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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.

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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.

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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.

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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

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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.

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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?

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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%.

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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.

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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.

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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-

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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

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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

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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

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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


Written options

Purchased options

Sources: Company filings 61

https://www.washtrust.com/�

Common Derivative Trading by Bank Size

Money-Center Banks National Banks Community Banks

Types of Contracts Offered to Clients (Cont’d)

Commodity contracts

Swaps


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

https://www.washtrust.com/�

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


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


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


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)


5.00%

Floating Rate

Floating Rate

5.00% (4.75% base)

Non-interest Income $$ (25 bps spread)


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.

134

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.

135

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

136

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

137

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

138

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.

139

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

140

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


Floating Rate Loan

Loan Customer Floating Rate

Floating Rate Loan

Bank


Dealer

Back-to-Back Example



5.00%

Floating Rate

Floating Rate

5.00% (4.75% base)

Non-interest Income $$ (25 bps spread)


141

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.

142

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

143

Mark H. Price, KPMG [email protected], 202.533.4364 Ron Copher, Glacier Bancorp [email protected] Justin Weiss, KPMG [email protected], 949.885.5848 Jeremy M. Josse, KPMG [email protected], 212.954.2814 David L. Konop, KPMG [email protected], 313.230.3360

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