Let’s talk tax
03 September 2019
The RMA is seeking new guidance from the US government to end a long-running conflict between new regulation and historic tax rules that is crippling market liquidity for fixed-term loans
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Against the backdrop of growing borrower demand for longer-term loans, driven by regulatory incentives, the Risk Management Association (RMA) has waded into the murky waters of US tax law to resolve a four-decade-long dispute on whether fixed-term loans should be exempt from capital gains tax.
The RMA’s tax committee has sent a letter to the US Department of the Treasury and the Internal Revenue Service to highlight its concerns that a lack of clear and up-to-date guidance on Section 1058 of the Internal Revenue Code is causing friction with the adoption of post-crisis regulatory requirements.
In the letter, the RMA notes that “the current uncertainty with respect to the Section 1058 eligibility of fixed-term securities loans generally results in many securities lenders refraining from such lending activity, thereby diminishing liquidity in a segment of the capital markets encouraged by the financial regulations discussed above”.
It is this drain on market liquidity that the RMA is ideally seeking to resolve as it patently runs against the aims of US and international regulators to create a more stable market environment. But let’s start at the beginning.
How did we get here?
Since the 2008 financial crisis, regulators have been dissecting the victims of the crash in order to discover the causes of death and are now applying those lessons to create new regulatory frameworks that mitigate those risks. For the securities lending market this has largely come in the form of a slew of reforms designed to encourage a move towards term lending and improved balance sheet managment.
In this vein, the Basel Committee on Banking Supervision drafted the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) as part of a comprehensive package of regulatory requirements known as Basel III.
The LCR is a form of stress test for banks that aims to ensure that they are always holding enough high-quality liquid assets (HQLA) to meet their financial obligations for the next 30 days.
Meanwhile, the NSFR was scheduled to be effective on 1 January 2018 but is currently pending finalisation. It aims to promote market resilience over a longer time horizon by creating incentives for banks to fund their activities with more stable sources of funding on an ongoing basis.
George Rapalje, vice president and securities finance tax manager at State Street and chair of the RMA’s tax committee, explains: “There has been a clear regulatory push coming out of the 2008 financial crisis to change the way financial institutions (covered banks) fund their operations.”
“It was identified that much of what caused the crash was an extreme reliance on short-term funding coupled with the fact that that funding was used to finance illiquid longer-term investments.”
Since the LCR was fully implemented in 2015, the RMA has observed that it is driving borrowers into longer-term securities lending transactions, meaning terms that go from 30 days to up to a year. In isolation this trend is entirely within the market’s ability to adapt to, however, in the spider’s web of rules and red tape that now exists, nothing new can be overlaid without interacting and reacting with the existing framework—and herein lies the problem.
The problem
In the US, an ambition to move the market away from short-term funding is in stark contrast with the current interpretation of the tax rules under Section 1058, which does not include fixed-term lending.
Section 1058 was originally enacted in 1978 to give US taxable lenders confidence that when they engaged in securities lending transactions they would not generate capital gains income.
According to Rapalje, the issue centres on a lack of recent guidance on Section 1058, which has meant that for decades the market has been making do with an out-dated understanding of its application for term trades.
“The US Treasury really hasn’t issued much guidance under Section 1058. It proposed some regulations back in the early 1980s that were never finalised,” says Rapalje. “That is about the most formal guidance it has ever issued on the subject, which is astonishing given the nominal value of securities lending transactions that are conducted every day in the US market.”
The key feature of these proposals outlined that, in order to be Section 1058 compliant for securities lending transactions, the lender must always have the right to recall with no more than five business days notice.
Rapalje notes that, back in the early 1980s, that was a settlement cycle, so the general interpretation today is that the lender must always have the right to recall, on-demand, and get all the securities returned in time to settle a sale.
However, although the proposed laws were never pursued, the lack of other formal guidance has meant that most lenders must rely on these draft regulations as their only guidance.
As a result, the commonly accepted reading of the law largely part puts fixed-term lending outside of the scope of Section 1058.
In its letter to the US Treasury, the RMA also noted that case law in intervening years has added further uncertainty around the application of the proposed regulations and the so-called five day rule to securities lending.
This reading of the tax code means that market participants are now caught between choosing to be eligible for tax on their term trades or taking the hit on their balance sheet to comply with LCR and NSFR for their short loans.
The situation is problematic for many, but especially so for some of the market’s biggest lenders, namely Sovereign Wealth Funds (SWFs), that rely on this interpretation to inform their tax positions in other areas.
The law of unintended consequences
On top of the problems with existing and incoming regulations clashing with Section 1058, there are also other sections of the tax code that indirectly reference Section 1058. The most significant being the one that grants SWFs tax immunity in the US.
Broadly speaking, SWFs are exempt from tax in the US, which is an extension of the sovereign immunity principle that exists in international law. However, this immunity is revoked if the fund conducts commercial activities, such as starting a business in the US to enjoy tax-free profit by virtue of being owned by a SWF. The relationship between this and securities lending is that the US Treasury’s regulations issued under the sovereign immunity principles specifically reference income from Section 1058 transactions as being exempt.
Rapalje explains: “This raises the question of, if you conduct a securities lending transaction that may not be Section 1058 compliant, such as a term trade, are you violating those sovereign immunity principles?”
The ambiguity around this issue, coupled with the heavy penalty that falling foul of the rules, means that many SWFs stay well clear of term trades to avoid the danger altogether. For agent lenders this means that a large portion of their lendable assets is closed off from being used to meet the growing demand for longer-term trades that new regulations, such as the LCR, have created.
“This [duality] creates a pretty strong tension between what certain financial regulators are pushing and tax law that simply hasn’t kept up. To an extent, there is certainly an effect on the liquidity in the space of the market that has been pushed by the Basel Committee and the Federal Reserve after 2008,” Rapalje concludes.
A solution to this thorny issue is far from obvious and may still be a long way off, but the RMA hopes to open a dialogue with the powers that could lead to some form of resolution for the market and end this long-running deadlock between new and old once and for all.
The RMA’s tax committee has sent a letter to the US Department of the Treasury and the Internal Revenue Service to highlight its concerns that a lack of clear and up-to-date guidance on Section 1058 of the Internal Revenue Code is causing friction with the adoption of post-crisis regulatory requirements.
In the letter, the RMA notes that “the current uncertainty with respect to the Section 1058 eligibility of fixed-term securities loans generally results in many securities lenders refraining from such lending activity, thereby diminishing liquidity in a segment of the capital markets encouraged by the financial regulations discussed above”.
It is this drain on market liquidity that the RMA is ideally seeking to resolve as it patently runs against the aims of US and international regulators to create a more stable market environment. But let’s start at the beginning.
How did we get here?
Since the 2008 financial crisis, regulators have been dissecting the victims of the crash in order to discover the causes of death and are now applying those lessons to create new regulatory frameworks that mitigate those risks. For the securities lending market this has largely come in the form of a slew of reforms designed to encourage a move towards term lending and improved balance sheet managment.
In this vein, the Basel Committee on Banking Supervision drafted the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) as part of a comprehensive package of regulatory requirements known as Basel III.
The LCR is a form of stress test for banks that aims to ensure that they are always holding enough high-quality liquid assets (HQLA) to meet their financial obligations for the next 30 days.
Meanwhile, the NSFR was scheduled to be effective on 1 January 2018 but is currently pending finalisation. It aims to promote market resilience over a longer time horizon by creating incentives for banks to fund their activities with more stable sources of funding on an ongoing basis.
George Rapalje, vice president and securities finance tax manager at State Street and chair of the RMA’s tax committee, explains: “There has been a clear regulatory push coming out of the 2008 financial crisis to change the way financial institutions (covered banks) fund their operations.”
“It was identified that much of what caused the crash was an extreme reliance on short-term funding coupled with the fact that that funding was used to finance illiquid longer-term investments.”
Since the LCR was fully implemented in 2015, the RMA has observed that it is driving borrowers into longer-term securities lending transactions, meaning terms that go from 30 days to up to a year. In isolation this trend is entirely within the market’s ability to adapt to, however, in the spider’s web of rules and red tape that now exists, nothing new can be overlaid without interacting and reacting with the existing framework—and herein lies the problem.
The problem
In the US, an ambition to move the market away from short-term funding is in stark contrast with the current interpretation of the tax rules under Section 1058, which does not include fixed-term lending.
Section 1058 was originally enacted in 1978 to give US taxable lenders confidence that when they engaged in securities lending transactions they would not generate capital gains income.
According to Rapalje, the issue centres on a lack of recent guidance on Section 1058, which has meant that for decades the market has been making do with an out-dated understanding of its application for term trades.
“The US Treasury really hasn’t issued much guidance under Section 1058. It proposed some regulations back in the early 1980s that were never finalised,” says Rapalje. “That is about the most formal guidance it has ever issued on the subject, which is astonishing given the nominal value of securities lending transactions that are conducted every day in the US market.”
The key feature of these proposals outlined that, in order to be Section 1058 compliant for securities lending transactions, the lender must always have the right to recall with no more than five business days notice.
Rapalje notes that, back in the early 1980s, that was a settlement cycle, so the general interpretation today is that the lender must always have the right to recall, on-demand, and get all the securities returned in time to settle a sale.
However, although the proposed laws were never pursued, the lack of other formal guidance has meant that most lenders must rely on these draft regulations as their only guidance.
As a result, the commonly accepted reading of the law largely part puts fixed-term lending outside of the scope of Section 1058.
In its letter to the US Treasury, the RMA also noted that case law in intervening years has added further uncertainty around the application of the proposed regulations and the so-called five day rule to securities lending.
This reading of the tax code means that market participants are now caught between choosing to be eligible for tax on their term trades or taking the hit on their balance sheet to comply with LCR and NSFR for their short loans.
The situation is problematic for many, but especially so for some of the market’s biggest lenders, namely Sovereign Wealth Funds (SWFs), that rely on this interpretation to inform their tax positions in other areas.
The law of unintended consequences
On top of the problems with existing and incoming regulations clashing with Section 1058, there are also other sections of the tax code that indirectly reference Section 1058. The most significant being the one that grants SWFs tax immunity in the US.
Broadly speaking, SWFs are exempt from tax in the US, which is an extension of the sovereign immunity principle that exists in international law. However, this immunity is revoked if the fund conducts commercial activities, such as starting a business in the US to enjoy tax-free profit by virtue of being owned by a SWF. The relationship between this and securities lending is that the US Treasury’s regulations issued under the sovereign immunity principles specifically reference income from Section 1058 transactions as being exempt.
Rapalje explains: “This raises the question of, if you conduct a securities lending transaction that may not be Section 1058 compliant, such as a term trade, are you violating those sovereign immunity principles?”
The ambiguity around this issue, coupled with the heavy penalty that falling foul of the rules, means that many SWFs stay well clear of term trades to avoid the danger altogether. For agent lenders this means that a large portion of their lendable assets is closed off from being used to meet the growing demand for longer-term trades that new regulations, such as the LCR, have created.
“This [duality] creates a pretty strong tension between what certain financial regulators are pushing and tax law that simply hasn’t kept up. To an extent, there is certainly an effect on the liquidity in the space of the market that has been pushed by the Basel Committee and the Federal Reserve after 2008,” Rapalje concludes.
A solution to this thorny issue is far from obvious and may still be a long way off, but the RMA hopes to open a dialogue with the powers that could lead to some form of resolution for the market and end this long-running deadlock between new and old once and for all.
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