Seven tax implications for banks under Dodd-Frank financial reform
While the Dodd-Frank Act recently passed by US lawmakers contains few explicit tax sections, its provisions may have significant tax implications for financial institutions. To assess the impact on your bank, loop your tax departments and tax advisors into discussions about the new law early on. We identify seven areas of focus.
- Volcker Rule limits banks' use of hedge funds and private equity funds
Because of the limitations placed on banks' use of hedge funds and private equity funds, banks may need to consider spinning off parts of their operations or otherwise disposing of their interests. As these actions would have significant tax consequences, companies need to consult with their tax departments and tax advisors to ensure the actions undertaken are as tax-efficient as possible.
- Capital requirements: trust preferred securities no longer qualify as Tier 1 capital
The phasing out of trust preferred securities means a financial institution may be losing a tax-efficient form of raising capital. Unless trust preferred securities are replaced with another hybrid-type security that qualifies as debt financing for US tax purposes, financial institutions potentially face a tax increase.
- OTC derivatives: separating swap activities
The Act generally requires that most swap contracts be centrally cleared and/or exchange-traded. However, gains or losses from certain kinds of swaps are not subjected to the rules under Section 1256, so taxpayers will be allowed to apply the same tax treatment for these swaps as they did before the Act was enacted. Some banks will need to restructure their operations to separate those swap activities, which could have significant tax consequences. Also, because the IRS knows many companies engage in these swaps, their use could subject companies to increased audit scrutiny.
- Recovery and resolution planning (“living wills”)
The Act requires certain financial institutions develop “living wills” that outline how they will wind down their business if faced with severe financial distress or failure. After drafting a living will, companies should review them periodically to ensure they continue to address the tax issues most relevant to the current state of their business.
- New assessments on financial institutions
While lawmakers ultimately decided not to include a bank tax proposal in the final legislation, the Act does require financial regulators to impose several different assessments on banks and other financial institutions. These assessments are intended to offset the increased cost of the governments' new responsibilities under the Act. These assessments should be tax-deductible, as it does not appear they are considered fines or penalties or are otherwise an income tax. Financial institutions should continue to monitor the status of the bank levy, as it could still be enacted in future legislation.
- Incentive compensation plans may need to be modified
To avoid violating the Act's prohibition on inappropriate risk taking, companies will need to examine their incentive compensation plans and assess whether they encourage recipients to take inappropriate risks. If they do, companies will need to modify their plans to comply with the new guidance.
- No double tax on policies in surplus lines insurance markets
The Act provides that a policyholder's home state will gain the sole tax collection and regulatory authority over multistate insurance policies in the non-admitted (surplus lines) insurance and reinsurance markets. Under current law, most states require payment of an allocated portion of tax on multistate risks, but several state statutes impose the tax on the entire gross premium of a multistate risk, creating a “double tax” on a portion of the premium in some transactions. The provision in the Act would prevent such double taxation by providing that the policyholder's home state would have the sole tax collection and regulatory over such policies.
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