Bank Tax InstituteCapital Markets: Recent Tax Developments

Larry Salva – CitigroupStephen Borman – KPMGJack Burns – EY

November 6, 2014

3

Introduction

TOPICS:► Application of the Economic Substance Doctrine: Recent Developments in FTC Generator Cases

► (Bank of NY Mellon Corp., BB&T Bank, Sovereign Bank (Santander), Wells Fargo, AIG).► Other Applications of the Economic Substance Doctrine

► Dow Chemical loses its appeal to the Fifth Circuit in Chemtech Royaty Associates.► Application of Debt v. Equity Analysis: Tyco► Inversions and Recent Treasury Action► Visa B Share: CCA Guidance► Dividend Arbitrage ► Base Erosion and Profit Shifting (BEPS) ► Miscellaneous (Hedging, §265, DOJ Settlements, Anticipated Extension of Tax Exemption for Mortgage Debt

Forgiveness)

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Application of the Economic Substance Doctrine: Recent Developments in FTC Generator Cases

Why these cases are relevant beyond FTC generators: Potential for expanded application, beyond the potential denial of FTC’s in structured finance transactions.

Bank of NY Mellon Corp. v. Comm’r, 140 T.C. 15 (Feb. 11, 2013), as modified byT.C. Memo. 2013-225 (Sep. 23, 2013) – Decision appealed to Second Circuit Court of Appeals (briefs filed on Jun. 12, 2014 and Sep. 25, 2014).

Facts► BNY transferred income-producing US assets to Trust Arrangement, referred to as

“STARS.”► Trust became subject to UK taxes on its income, which were claimed as foreign tax

credits (“FTCs”) for US federal income tax purposes.► BNY obtained $1.5 billion of below market cost financing from a UK bank. The

financing was approximately 300 bps below market because the UK bank also obtained UK tax benefits from the UK Trust Arrangement and provided rebate payments to BNY equal to a portion of the UK Bank’s UK tax benefits.

Tax Court Holdings► The Trust lacked economic substance► The result of the Tax Court’s determination that the transaction lacked economic

substance was as follows:► FTCs disallowed ► Deduction for foreign taxes not allowed► Interest expense deductions allowed► Income from rebate payments exempted from tax► No penalties (not assessed)

.

Initiation:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

US Assets

Equity (for UK tax purposes)

$“Repo Loan”

(for US tax purposes)

Ongoing:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

5

Application of the Economic Substance Doctrine: Recent Developments in FTC Generator Cases

Bank of NY Mellon Corp. v. Comm’r [Cont’d]

Appeal to the Second Circuit Court of Appeals (briefs filed on Jun. 12, 2014 and Sep. 25, 2014)► Addressing a broad array of issues, including:

► Foreign tax as an incremental pre-tax expense, despite Compaq, IES. ► Treatment of the reduction in borrowing costs.► Treatment of borrowing transactions, in general.

► U.S. government requests Court of Appeals to affirm Tax Court’s decision that the transaction lacked economic substance but overrule the Tax Court’s decision to allow interest expense deductions.

► Note: The resulting consequences that flow from a decision that a transaction lacks economic substance, per the Tax Court, is to disregard all consequences of the transaction, or portion thereof, that is treated as a sham. This conflicts with authorities, such as the Third Circuit decision in ACM, which require recognition of all economic items of income or expense.

Initiation:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

US Assets

Equity (for UK tax purposes)

$“Repo Loan”

(for US tax purposes)

Ongoing:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

6

Application of the Economic Substance Doctrine: Recent Developments in FTC Generator Cases

BB&T Bank (Salem Fin., Inc. v. U.S., 113 AFTR 2d 2014-434 (2014))

Facts► Similar facts to the Bank of NY Mellon Corp. case.► “STARS” transaction, involving FTCs.► Court of Federal Claims held that BB&T Bank’s transaction lacked economic

substance.

Compare results of Bank of NY Mellon Corp. vs. BB&T Bank:

In 2014, a reconsideration by the Court of Federal Claims resulted in no change in the previous decision (described above). BB&T Bank then appealed to the Federal Circuit Court of Appeals (briefs filed on Aug. 14, 2014 and Sep. 15, 2014).

Taxpayer’s brief addresses a broad range of issues in establishing that the transaction has economic substance.

Initiation:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

US Assets

Equity (for UK tax purposes)

$“Repo Loan”

(for US tax purposes)

Ongoing:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

Tax Items Considered Bank of NY Mellon Corp. BB&T Bank

FTCs Disallowed Disallowed

Deduction for foreign taxes Disallowed Disallowed

Deduction for interest expense Allowed Not allowed

Income from rebate payments Excluded Included

Penalties No penalties (not assessed) Penalties upheld

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Application of the Economic Substance Doctrine: Recent Developments in FTC Generator Cases

Santander Holdings USA, Inc. v. U.S. (also referred to as Sovereign Bank, U.S. District Court, MA) – To be appealed to the First Circuit Court of Appeals.

Facts► Similar facts to the Bank of NY Mellon Corp. and BB&T Bank cases.► “STARS” transaction, involving FTCs.

Based on Ruling on Partial Summary Judgment Motion:► Rebate income is not a “tax effect” and, therefore, is recognized as part of the Bank’s

economic profit from the transaction.► If the Court also concludes that foreign tax expense is not an expense in determining

economic profit, the transaction would be deemed to have substantial economic profit and could, therefore, be considered to have economic substance.

► Taxpayer’s brief for summary judgment filed on Jan. 30, 2014.► IRS reply brief filed on Mar. 5, 2014.

Wells Fargo & Co. (“STARS” transactions involving FTC’s): Report of Special Master for the U.S. District Court for the District of Minnesota (Jul. 21, 2014).► Numerous issues addressed by the Special Master, including treatment of the

reduction in borrowing costs as an item of pre-tax income.► Additional issues to be addressed by District Court, including the subjective business

purpose test and the impact of IES.

AIG FTC Generator Case (not a “STARS” transaction):► Interlocutory appeal from the U.S. District Court for the Southern District of New York

to Second Circuit Court of Appeals (AIG brief dated Jun. 30, 2014).►Unlike most other cases, Judge Stanton defines the issues as a single, narrow

question: Is the reduction in borrowing cost a “tax effect”?

Note: The Second Circuit is currently hearing two appeals: AIG (narrowly framed) and BNY Mellon (broadly framed).

Initiation:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

US Assets

Equity (for UK tax purposes)

$“Repo Loan”

(for US tax purposes)

Ongoing:

US Bank

Non-US Bank(UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

8

Other Applications Economic Substance Doctrine: Dow Chemicals loses its appeal to the Fifth Circuit in tax shelter case

Chemtech Royalty Associates, L.P. v. U.S., 114 AFTR 2d 2014-5940 (CA-5) (Sep. 10, 2014).►Tax shelter promoted by US investment bank.►High value, low tax basis assets (patents) were contributed to a partnership and were generating significant taxable income, as royalty income

was not offset by any tax depreciation.►Tax indifferent partners (foreign banks) were allocated a substantial amount of taxable income (in excess of their return, or economic income).

This was justified by an allocation of book (not tax) depreciation of patents to Dow Chemical.►Facts and structure similar to Castle Harbor case.►Shelter transaction had 10 year duration (i.e., 1993 - 2003).►Circuit Court upholds District Court’s decision to deny tax benefits on grounds that the partnership was a sham (foreign banks were lenders; not

partners).►Penalty issues remanded to District Court: valuation penalties are not inconsistent with characterization of the partnership as a sham.

Other:►On June 19, 2014, the US Supreme Court refused to review an Eighth Circuit decision that disallowed a loss from a contingent liability

transaction (WFC Holdings Corp. v. U.S., U.S. No. 13-1037, cert denied Jun. 9, 2014).

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Application of the Substance Over Form Doctrine in Recent Court Decisions

Barnes Group, Inc. v. Comm'r, T.C. Memo 2013-109 (Apr. 16, 2013) – Application of the substance-over-form doctrine to determine that a controlled foreign corporation (“CFC”) had paid a taxable dividend to its US Parent company. Appealed to the Second Circuit Court of Appeals (appeal briefs dated May 15, 2014 and May 29, 2014; oral arguments held Oct. 1, 2014).

Facts►Taxpayer structured a repatriation of cash from its CFC to the US parent without creating a taxable dividend or §956 inclusion. Specifically, one

of the Taxpayer’s foreign subsidiaries transferred foreign currency in exchange for a newly formed foreign entity's stock, the foreign currency was then transferred to a newly formed domestic entity in exchange for the newly formed domestic entity's stock, and the newly formed domestic entity converted the foreign currency into U.S. currency which was loaned to the Taxpayer.

Tax Court Holdings►The Tax Court held that the transfers of the foreign subsidiary's excess cash (which was eventually used to pay down the Taxpayer's debt) was

in substance a dividend. ►Further, the Tax Court held that the foreign subsidiary was not prevented from investing directly in the newly formed domestic entity, and thus

the newly formed foreign entity had no business purpose. ►The stated business purpose of the newly formed domestic entity was belied by the taxpayer's failure to respect the form of the reinvestment

plan by paying interest to the domestic entity on the putative loan, and the domestic entity's failure to pay preferred dividends to the foreign entity.

►Accordingly, the Tax Court disregarded the form of the transaction steps, and treated the transaction as a taxable dividend.

Second Circuit►At oral arguments on Oct. 1, 2014, Judge Lynch summarized. “If what you’re doing is the economic equivalent of a taxable transactions, the

transaction is taxable.” Such language does not bode well for Taxpayer’s appeal.

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Application of Debt v. Equity Analysis in Recent Court DecisionsTyco – (Tax Court petitions filed in 2013) – Debt owed by US Subsidiaries to a Luxembourg finance vehicle under an ultimate non-US Parent Company being challenged by IRS as equity; with corresponding disallowance of interest expense deductions by the subsidiaries.

►Through a merger, Tyco re-domiciled its US Parent to Bermuda in the late 1990’s and also levered-up certain US operating subsidiaries. The IRS challenged the interest deductions with respect to inter-company debt owed by Tyco’s US subsidiaries to the Luxembourg Co., on debt-equity grounds. (Note: some of the US subsidiaries were subsequently disposed of).

►Tyco maintains that the debt instruments had all the formal indicia of debt: fixed maturities, stated interest (all of which was paid), formal debt instruments, and, a capacity to service the debt payments, with supportive analysis. Its "intercompany loans were bona fide indebtedness for federal income tax purposes," the company said in court documents.

►Compare with other recent debt/equity cases that have been favorable to taxpayers, such as Scottish Power.

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Inversions and Treasury’s Response to Inversions (Sep. 22, 2014).The backdrop to the Tyco-IRS litigation was the re-domiciling of Tyco from the US to a non-US jurisdiction (i.e., Bermuda, initially, and Ireland, subsequently) and the U.S. base erosion result from levering-up US subsidiary operations. Tyco’s inversion transaction occurred in the late 1990’s (i.e., prior to the 2004 enactment of Section 7874, the US anti-inversion provision).

►Consider recent M&A transactions, involving US Acquiring Co. and non-US Target, which have permitted US companies to re-domicile, from the US, to a low-taxed jurisdiction:►Acquisitions in the following industries:

►Pharmaceutical►Media►Advertising►Consulting►Fast Food

►See Section 7874, regarding the treatment of Expatriating Entities.► In general, expatriating entities are treated as US entities after re-domiciling, or, their shareholders are subject to taxable gain in the US,

unless the re-domiciling involves a substantial change in stock ownership (e.g., in a stock-for-stock acquisition of a foreign target) and there are substantial non-US operations.

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Inversions and Treasury’s Response to Inversions (Sep. 22, 2014).

►Relevance to US Banks:►Although banks have over-arching regulatory constraints, preventing the re-domiciling of their Parent Co. or major banking subsidiaries, the

Investment Banking / Advisory Groups of US Banks are advising their US non-banking clients on the impact of re-domiciling. (This raises potential franchise-related issues for the re-domiciling company and its investment banking advisors, since re-domiciling is often a politically-charged issue in Washington, D.C.). In addition, clients of the bank may have investments impacted by inversion-related developments.

►Treasury’s Response to Inversions:►On September 22, 2014, Treasury took targeted steps to eliminate post inversion base erosion and to strengthen the ownership

requirements for application of the anti-inversion rules. (See Notice 2014-52 regarding application of §§ 304, 367, 956, 7701(l), and 7874).

►Legislative proposals are both narrow (targeting the inversions) and broad (using tax reform as a disincentive to invert).

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Visa B Shares (CCA Guidance)

Chief Counsel Advice 2014-11032.

Facts:► Visa B Shares were issued to Member Banks at the time of the Visa IPO of its A Shares to the public.► Visa had substantial litigation risks at the time of its IPO. Sales of B Shares were restricted (could only be sold to other B Shareholders)► B Shares are convertible into A Shares after resolution of litigation matters.► The conversion Ratio is subject to dilution if Visa litigation matters worsen.► CCA – Addressed the sale of B Shares, along with a derivative to compensate the buyer for any subsequent conversion dilution.

CCA Guidance:► A subsequent payment by Seller to Buyer, under the derivative contract, to compensate Buyer for post-sale conversion dilution, should be treated by Seller as

a capital loss (due to its relation to Seller’s initial capital gain from the share sale). The payment under the derivative contract should essentially be integrated with the share sale and should not be treated as a separate non-periodic payment (giving rise to an ordinary amortization deductions).

► Some B shareholders disagree with the CCA Guidance.

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Dividend ArbitrageBackground► In September, 2014, press coverage indicated that US bank regulators were

examining the risks and governance issues related to dividend arbitrage trading activity conducted by banks.

.Observations► Dividend Arbitrage on US equities has been curtailed by enactment of §871(m) and

related US tax guidance (to be discussed in our subsequent session today).► Dividend Arbitrage on non-US equities has given rise to financial risks to banks

(examples: Italy, Germany, Switzerland).► If the bank incurs a non-U.S. withholding tax on shares it acquires in dividend

arbitrage transactions, the ability to claim US FTC’s for such withholding taxes is subject to further risks under application of US tax law (§901(k)(4), economic substance, beneficial ownership)

► Banks must adopt country-by-country risk mitigation procedures to manage risk of backlash by issuing country.

► Discuss typical protocols and procedures..

Swap Illustration:

UK Sub of

US Bank

Total Return Swap

Expected Dividend to be Received by Hedge Fund:

Gross $100WHT ($30)NET of WHT $70

Shares

Hedge Fund

$80 dividend equivalent

Actual Dividend received by Bank:

Gross $100WHT ($15)NET of WHT $85

Bank receives $85 net and pays dividend equivalent of $80; earning a spread of $5 plus funding (and potential US FTC if the withholding tax is a non-US tax).

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Base Erosion and Profit Shifting (BEPS)

The OECD issued reports in September, 2014, on various Action Plans for the BEPS Initiative. Some highlights include:

►Action 1 (on the digital economy): The Report discusses some options, such as modifying PE rules to potentially recognize a PE nexus based on a significant digital nexus, introducing a withholding tax regime for digital transactions and modifying existing VAT regimes. No specific measures are recommended and the digital economy issues appear to have little applicability to bank activity, such as mobile banking.

►Action 2 (on cross-border hybrid mismatch arrangements): There is an ambitious recommendation for participating countries to amend theirdomestic laws to neutralize the mismatch in tax treatments form hybrid instruments. The recommendations apply to structured arrangements and related party transactions. Corresponding changes to treaties are also recommended. Further analysis and development, however, is required for ordinary course of business transactions, such as securities repos and stock loans; with apparent acknowledgement that ordinary course of business repos and stock loans should not be impacted.

►Action 5 (on countering harmful practices): The Report describes three outputs anticipated in 2015:►A review of member country preferential regimes►A strategy to include non-OECD member countries►Revisions to the existing framework for analyzing whether regimes are harmful.

►Action 6 (on preventing treaty benefits in inappropriate circumstances): The Report recommends the inclusion of anti-abuse rules in the OECD Model Tax Convention. The Report includes an LOB provision similar to the LOB provision in US treaties and a GAAR provision similar to the “main purpose” test found in the UK treaties.

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Base Erosion and Profit Shifting (BEPS) [cont’d]

►Action 8 (on transfer pricing aspects of intangibles): The recommendations contain revised standards for transfer pricing of intangibles and additional standards with respect to comparability and transfer pricing. Intangibles are more likely to exist in consumer banking (e.g., core deposits, credit card customer relationships) than in corporate / investment banking. Where applicable, further OECD developments are worth monitoring.

►Action 13 (on country-by-country reporting): The CBC reporting is aimed at ensuring better transparency for tax administrations by providing them with adequate information to conduct transfer pricing risk assessments. Open issues include how reports are to be provided to tax authorities and whether they would be publicly available.

►Also, see: Barclays’ CRD IV Report, a publicly available UK report that contains country-by-country information.

►Action 15 (on developing a multilateral instrument to modify bilateral tax treaties): The Report examines the feasibility of a multilateral instrument as a way to expeditiously implement treaty measures developed under the other actions.

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MiscellaneousHedging Identification – Updates:► Due to the bank regulatory reforms, the manner in which hedges are executed may

have changed and the use of inter-company and intra-company derivatives, as part of the overall hedge execution, may have increased significantly for certain banks.

Illustration:

US Parent

Non MTM Security

(hedged item)

3rd Party

Sub 1 does not MTM the security or the swap

Q(1): How should the tax identification be described? (See Treas. Reg. Sec. 1.1221-2(e)(2)

Q(2): How are historical tax identification programs impacted by new regulatory identifications, to be implemented in 2015, for purposes of compliance with the Volcker Rule?

BankSubSub 1

Bank Sub MTM’s both Swaps

SwapSwap

Section 1234A - Update:► Pilgrim’s Pride Corp., 141 T.C. No. 17 (Dec. 11, 2013) treats shareholder rights as

invoking Section 1234A, but the unique facts in this case might argue for a narrow application of this decision.

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Miscellaneous [cont’d]

Section 265 – Update:►Although the low interest rate environment and the favorable treatment of interest on inter-company loans (for §265 purposes) tend to minimize

the §265 disallowance amount for banks holding tax exempt municipal bonds, §265 issues continue to arise, partly due to movements of bonds within the US consolidated tax return group, which may be prompted by regulatory change.

►Contrast the favorable holding in PSB Holdings Inc. v. Comm.’r, 129 T.C. 131 (2007), in support of separate, member-by-member §265 calculations within the consolidated tax return, and the anti-abuse rule in Revenue Ruling 90-44, 1990-1 C.B. 54 (Jan. 1990), which applies alternative §265 calculations if necessary to prevent avoidance of tax.

►Contrast the inter-company purchases of tax exempt bonds with inter-company contributions of tax-exempt bonds.

Settlements – Deductible Portions of DOJ Settlement Payments:►Several banks have agreed to settlements with the Department of Justice (“DOJ”), providing for a portion devoted to consumer relief (deducted

as bad debts), a portion designated as a penalty (not deductible under §162(f)), and, a portion intended to be for compensatory restitution (which should be deductible, since it would be outside the scope of the §162(f) non-deductibility provision). Authorities potentially casting doubt on the deductibility of the latter portion of the settlement, such as Talley Industries, Inc. v. Comm.’r, 88 AFTR 2nd 2001-702718, 18 Fed. Appx. 661 (9th Cir. 2001), should be of no significant concern here, because, unlike the facts in Talley, the DOJ settlement agreement specifically designated the non-deductible penalty portion; thus, clearly identifying the remaining portions as deductible compensatory restitution and not a non-deductible penalty.

Mortgage Debt Forgiveness:►The tax exemption for mortgage debt forgiveness, enacted in 2007, expired at the end of 2013. It is anticipated that the exemption will be

extended to cover mortgage debt forgiveness in 2014 and 2015, as part of the Extenders legislation. However, until passage of the Extenders legislation, uncertainty exists.

► In this regard, one of the recent mortgage-related settlements with the DOJ required that funds be set aside to defray part of the tax cost of mortgage debt forgiveness, pending an extension of the tax exemption. The funds set aside for this purpose will be paid to parties assisting mortgage borrowers, if not needed because of a retroactive extension of the exemption.

►Also, may lien release precede the discharge?

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Caveat and Limitations

Due to the preliminary nature of this document, it does not constitute tax advice or an opinion and hence cannot be relied upon for any purpose, including penalty protection. In order for EY to render tax advice or issue an opinion, additional steps may be required including, but not limited to, research, obtaining written representations from management, and/or verifying the facts upon which the opinion would be based.