Post-Financial Crisis Regulation and the U.S. Tax Treatment of Bank Capital Securities

Abstract

The article discusses the U.S. federal income tax characterization of equity-flavored debt instruments issued by banks in compliance with bank regulatory rules adopted after the financial crisis of the late 2000’s.

Banks and other financial institutions must issue financial instruments that qualify
as raising capital in order to satisfy regulatory requirements. Banks also must issue financial instruments that facilitate their resolution if they become financially distressed. A portion, often a large portion, of these instruments may be issued in the legal form of debt. U.S. tax law has certain requirements for a financial instrument with the legal form of debt to be respected as indebtedness for tax purposes. The intersection between these two sets of rules can be vexing, since it is inherent in a capital instrument with the legal form of debt that it is subordinate to protected creditors – for example, depositors in a bank – and frequently has deferral or non-payment provisions not wholly consistent with a tax lawyer’s notion of conventional debt.

A body of historic tax case law and rulings addresses the classification of legal-form debt issued to satisfy regulatory requirements applicable to banks and other financial institutions. That law typically is deferential to regulatory requirements. The issue discussed by this article is whether that deference extends to the new forms of legal-form debt instruments that banks and their affiliates are issuing pursuant to the bank regulatory rules that have been adopted since the financial crisis of the late 2000’s.

The article summarizes bank capital and resolution rules, in lay terms suitable for a tax audience; describes the different types of bank capital and resolution instruments that banks issue; discusses the investor perspective for why the U.S. federal income tax characterization of these instruments matter, including characterization, timing, and other issues; and finally lays out a framework for analyzing whether bank capital and resolution instruments should be treated as debt or equity for U.S. federal income tax purposes.

It is believed that this article was the first to discuss debt-equity tax issues with respect to debt instruments issued by banks in compliance with bank regulatory rules adopted after the financial crisis of the late 2000’s.

Keywords: tax, bank, capital, resolution, debt, equity, regulation, hybrid, investor, issuer, Basel, FSB, TLAC, QDI, OID, PFIC, FATCA

JEL Classification: K34, K23, G21, G23, H25